Our article addresses legal due diligence and the share purchase agreement in mergers and acquisitions, explaining the scope of the review, its relationship with the seller's warranty against defects, representations and warranties, indemnity mechanisms, price adjustment, conditions precedent and merger control clearance.
Acquiring a company appears to consist of a transfer of shares; in reality, what is acquired is that company together with its past, with all its obligations, its litigation, its tax exposure, its contracts and the problems that have not yet surfaced. A tax inspection that comes to light months after closing, an unknown guarantee undertaking, an expired licence or an action brought by a former employee may destroy the economics of the transaction entirely. For this reason, two documents lie at the heart of merger and acquisition transactions; the legal due diligence report setting out the target company's real position, and the share purchase agreement determining on whom the risks identified in that review will fall. These two cannot be thought of separately; whatever the review has found, the agreement must manage. This article comprehensively examines the legal due diligence process, the scope of the review, the relationship between the review and the seller's warranty against defects, the structure of the share purchase agreement, representations and warranties, indemnity and price adjustment mechanisms, conditions precedent and merger control clearance.
1. The Stages of a Merger and Acquisition Transaction
A merger or acquisition is not a sale taking place in a single moment, but a process consisting of successive stages. The process generally begins with the parties' first contact and a mutual expression of interest. At this stage a confidentiality agreement is signed in order to protect the information to be shared during the discussions. Thereafter a letter of intent or preliminary protocol setting out the parties' basic understanding, most of whose provisions are non-binding, is drawn up; this document determines the structure of the transaction, an indicative price, the exclusivity period and the timetable. This is followed by the legal, financial and tax review stage. The results of the review are directly reflected in the negotiation of the share purchase agreement. The signing of the agreement does not mean that the transaction is complete; by signing, the parties merely come under an obligation to perform the undertakings determined in the agreement. The moment ownership genuinely changes hands is the closing date. Between signing and closing there is an interim period devoted to the fulfilment of the conditions precedent. At closing the transfer of shares takes place, the price is paid, the change of management is effected and the necessary registrations are completed. The correct structuring of this staged process is the basis of the transaction's legal security.
2. The Concept and Purpose of Legal Due Diligence
Legal due diligence is the process of systematically reviewing the legal position of the target company. This process has three basic purposes. The first purpose is to verify the target company's legal existence and good standing; it is confirmed that the company was duly incorporated, that it is capable of continuing its activity and that the shares subject to the transfer genuinely belong to the seller. The second purpose is the identification of significant risks; these risks, known in practice as red flags, may be of a gravity capable of changing the structure of the transaction or of leading to its abandonment. The third purpose is to determine how the identified risks will be reflected in the transaction value and in the structure of the agreement; a risk is either deducted from the price, or tied to the seller's representation and warranty, or covered by a specific indemnity provision, or made a condition precedent so that its remedy is required, or deliberately assumed by the buyer. In this respect due diligence is not merely an information-gathering exercise but an instrument of risk allocation directly guiding the design of the agreement. The scope and depth of the review are determined according to the size of the transaction, the sector and the parties' risk appetite.
3. The Scope of the Review: Corporate Structure and Shares
The first and most critical heading of the legal review is the company's corporate structure and the legal position of the shares. In this context the incorporation documents, the articles of association and all amendment texts are first reviewed; it is verified that the company was duly incorporated and that the current version of the articles is established. Thereafter the chain of title to the shares is examined; it must be confirmed that all transfers the shares have undergone from incorporation to the present are unbroken and in due form. It is checked whether the share ledger has been kept up to date and whether the records correspond with the trade registry data; a discrepancy between these two sources is a serious problem frequently encountered in practice and capable of rendering the validity of the transfer debatable. It is investigated whether there is any pledge, attachment or other encumbrance over the shares. Transfer restriction provisions in the articles of association, privileged shares and special quorum requirements provided for certain decisions are examined; these provisions may require additional approvals for the transfer to be effected. Finally, the persons authorised to represent and bind the company, the internal management directive and any powers of attorney granted are checked. Since a deficiency under this heading may shake the foundation of the transaction, the review is conducted with particular rigour here.
4. The Scope of the Review: Contracts, Assets and Compliance
Following the corporate structure, the second major limb of the review is the company's commercial relationships and assets. In this context important customer and supplier contracts, distributorship and agency relationships, loan agreements, guarantee and surety undertakings, lease agreements and licence agreements are examined. The type of provision to which particular attention is paid in this review is change of control provisions; many commercial contracts grant the counterparty a right of termination when the company's shareholding structure changes, and this provision may cause the company to lose its most valuable contracts after the transfer. As regards assets, immovable property, title deed records, encumbrances over them, machinery and equipment, and intellectual property rights are examined; it is verified whether the trademarks, patents and domain names are genuinely registered in the company's name. On the employment side, employment contracts, severance liabilities, union relations and pending labour actions are assessed. On the compliance side, operating permits and licences, environmental legislation, data protection compliance, competition law risks and, where relevant, the position as regards sanctions lists are reviewed. Tax and litigation files are likewise addressed as separate headings.
5. Conducting the Review and the Report
The due diligence process is conducted in practice by a particular method. The process begins with the transmission to the seller of an information and document request list prepared by the buyer's side. The seller uploads the requested documents, today generally, to a virtual data room; this environment both organises the flow of documents and records which document was shared and when. This record constitutes decisive evidence in any future dispute as to what the buyer knew and did not know. Supplementary question lists are sent to the seller in respect of matters found incomplete or contradictory during the review. The legal due diligence report prepared at the end of the process sets out systematically the matters identified and the risks they give rise to. A good report does not confine itself to listing findings; it classifies each risk according to its degree of importance, assesses the likelihood of the risk materialising and its probable financial impact, and, most importantly, offers a concrete proposed solution for each risk. This last dimension of the report is what transforms the review from a pile of documents into a transaction strategy and is used directly in the negotiation of the share purchase agreement.
6. The Relationship Between the Review and the Warranty Against Defects
The legal review has, as regards Turkish law, an exceedingly important consequence that is often overlooked. Since a contract of sale lies at the basis of merger and acquisition transactions, the seller's warranty against defects comes onto the agenda. By conducting a due diligence review of the target company, the buyer is legally deemed to have inspected what is sold. The natural consequence of this is as follows; the review conducted produces the result that the seller is not liable for defects that are not hidden, that is, that could have been noticed through the review. In other words, where the buyer has failed to see a risk it could have seen during its review, the possibility of subsequently placing that risk on the seller narrows significantly. There is an important exception to this rule; where the seller has knowingly and fraudulently concealed certain matters and the defects could not be identified for this reason, the seller's warranty liability continues. This legal framework produces two practical consequences. First, from the buyer's point of view, conducting a comprehensive review is mandatory not only in order to obtain information but in order to prevent a loss of rights. Second, the buyer must expressly secure the risks it has or has not identified through the review by means of the representations and warranties in the agreement.
7. The Structure of the Share Purchase Agreement
The share purchase agreement is the principal document prepared in line with the due diligence report and establishing the entire legal architecture of the transaction. The typical structure of the agreement follows a certain order. The definitions section clarifies all technical concepts used in the text and prevents disputes of interpretation. The sale and transfer provisions determine the shares subject to transfer, the price and the payment structure. The conditions precedent list the conditions that must be fulfilled for the transaction to be completed. The closing provisions regulate step by step which actions will be taken in which order on the closing day. The representations and warranties section contains the assurances the parties give one another. The indemnity provisions establish the mechanism that will operate in the event of a breach of these assurances. These are followed by post-closing undertakings, non-compete and confidentiality provisions, and the governing law and dispute resolution provisions. The distinguishing feature of a well-structured share purchase agreement is that it transforms the review findings into measurable and enforceable contractual protections rather than abstract statements of aspiration. The annexes to the agreement are no less important than the text; disclosure schedules and asset inventories are the documents that in fact draw the limits of liability.
8. Representations and Warranties
The longest and most heavily negotiated section of the share purchase agreement is the representations and warranties. By these provisions the seller undertakes that the qualities the target company is asserted to possess genuinely exist. The difference between the qualities represented and the company's real position is legally characterised as a defect and gives rise to a right to compensation. Typical headings of representations and warranties run in parallel with the headings of the legal review; that the company was duly incorporated and is capable of continuing its activity, that the shares belong to the seller and are free of encumbrances, that the financial statements are accurate, that there are no debts or undertakings other than those disclosed, that tax obligations have been discharged, that there is no pending or threatened litigation, that the important contracts are valid, that the intellectual property rights belong to the company, that employment legislation has been complied with and that the necessary permits and licences are in place are among these headings. Moreover, obtaining from the seller a separate representation that the information and documents it provided during the due diligence process are accurate and complete and that it has withheld no material information is an established and exceedingly important protection in practice. Representations and warranties are the provisions that in fact draw the limits of the seller's liability.
9. The Disclosure Schedule and the Knowledge Exception
Representations and warranties are not given in absolute terms; the seller sets out by means of a disclosure schedule the matters constituting exceptions to these representations. This schedule discloses, for example, certain pending actions under the representation that there is no litigation, and existing credit relationships under the representation that there is no indebtedness. A matter included in the disclosure schedule is not deemed a breach of the relevant representation and as a rule cannot be made the subject of an indemnity claim. This structure constitutes one of the most sensitive areas of the negotiation. The seller wishes to keep the schedule as broad as possible in order to narrow its liability, and even, by means of general statements, to have every document shared in the data room deemed disclosed. The buyer, on the other hand, seeks to keep the schedule narrow and requires that only matters expressly and comprehensibly stated be treated as exceptions; for treating a data room of thousands of pages as wholly disclosed renders the representations and warranties inoperative. The understanding reached at this point directly determines the risk allocation of the transaction. The approach recommended from the buyer's point of view is that disclosure be deemed valid only where made expressly in the schedule and by reference to the relevant representation.
10. Indemnity Mechanisms and Limitations
The indemnity mechanism coming into play in the event of a breach of the representations and warranties is the second centre of gravity of the share purchase agreement. The general indemnity obligation provides that the seller will make good the buyer's loss where the representations prove untrue. Alongside this, specific indemnity provisions are regulated for concrete and known risks identified during due diligence; for example, it may separately be agreed that the seller will be fully liable for the outcome of a particular pending tax inspection. Indemnity liability is generally made subject to various limitations. A de minimis threshold provides that claims below a certain amount cannot be brought and prevents trivial claims. An aggregate threshold ensures that no right of claim arises until the total of individual claims reaches a certain level. A cap determines the upper limit of the seller's total liability and is most often agreed as a percentage of the purchase price. A time limitation determines until what date the representations may be relied upon; under headings such as tax and environment this period is generally kept longer. The balanced structuring of these limitations is the most technical part of the negotiation.
11. Price Adjustment and Security Mechanisms
The financial position of the target company may change between the date the agreement is signed and the closing date. How this change will be reflected in the price is resolved by one of two different methods. The first method is the completion accounts method; under this method the price is adjusted according to financial statements prepared as at the closing date, on the basis of net debt and working capital items. This method gives a result closer to reality, but carries the risk of post-closing calculation and of disputes connected with it. The second method is the locked box method; here the price is fixed on the basis of a balance sheet of an earlier date and it is undertaken that no value will leave the company from that date onwards. This method provides certainty and simplicity, but increases the interim period risk for the buyer. Security mechanisms are also established so that indemnity claims can in fact be collected. The most common is that a portion of the price is held in a blocked account for a certain period; this amount constitutes security against claims that may arise. Alternatively, methods such as deferring part of the price, obtaining a bank letter of guarantee or taking out warranty and indemnity insurance may be used.
12. Conditions Precedent and the Interim Period
The period between the signing of the share purchase agreement and closing is the most fragile stage of the transaction. The conditions that must be fulfilled during this period are listed in the agreement as conditions precedent. Among typical conditions precedent are obtaining merger control clearance, procuring the necessary approvals in activities subject to the authorisation of sectoral regulators, obtaining consent to the change of control from lending banks, securing board or general assembly approvals required by transfer restriction provisions in the articles of association, and the remedying of certain deficiencies identified during due diligence. Where these conditions are not fulfilled, closing does not take place and the parties are released from the agreement. During the interim period certain conduct obligations are also imposed on the seller; undertakings such as managing the company in the ordinary course of business, refraining from extraordinary expenditure and undertakings, not terminating important contracts and not disposing of assets fall within this scope. These obligations prevent the buyer from encountering at closing a company different from the one it saw at signing. Moreover, a right to walk away from the agreement may be granted to the buyer in the event of a material adverse change.
13. Merger Control Clearance
A significant portion of merger and acquisition transactions is subject to clearance as a matter of competition law. Transactions exceeding certain turnover thresholds and giving rise to a change of control require the approval of the competition authority in order to acquire legal validity. The failure to obtain this clearance not only leads to an administrative fine, but may give rise to the far graver consequence of the transaction not acquiring legal validity. For this reason it is mandatory to assess at an early stage of the transaction whether the turnover thresholds are exceeded and whether a notification obligation arises. In a notifiable transaction the clearance process directly affects the closing timetable; for this reason obtaining clearance is regulated as a condition precedent and the parties' obligation to cooperate in this process is written into the agreement. What the parties' rights and obligations will be should clearance not be obtained must also be determined in advance. The competition law dimension is not limited to clearance; the non-compete undertakings provided for between the parties after the transaction must also remain within limits acceptable as a matter of competition law, that is, within what the transaction requires as regards duration, geographical area and subject matter.
14. Mistakes Frequently Made in Practice
Certain mistakes are frequently repeated in merger and acquisition transactions. The first mistake is conducting the due diligence process superficially or shortening it under time pressure; this deficiency, within the framework of the duty of inspection under Turkish law, makes it difficult for the buyer to claim subsequently. The second mistake is the failure to reflect the review findings in the agreement; a risk that has been identified but has no counterpart in the agreement remains entirely with the buyer. The third mistake is allowing the disclosure schedule to expand without control; treating every document in the data room as disclosed nullifies the representations and warranties. The fourth mistake is the unbalanced structuring of the indemnity limitations; a very low cap or a very short limitation period leaves the protection in appearance only. The fifth mistake is overlooking change of control provisions; the termination of the most valuable customer contract after the transfer may destroy the economics of the transaction. The sixth mistake is the late realisation of the need for merger control clearance. The seventh mistake is the failure to remedy, before closing, discrepancies between the share ledger and the trade registry records; this deficiency may render even the validity of the transfer debatable.
15. Conclusion and Practical Recommendations
Merger and acquisition transactions are processes of high technical intensity in which the legal review and the design of the agreement complement one another. The basic considerations in this field may be summarised as follows. Due diligence is not a formality but the core stage determining the risk architecture of the transaction, and under Turkish law it is directly connected with the buyer's duty of inspection; an incomplete review makes a subsequent claim more difficult. Every risk identified in the review must find a concrete counterpart in the agreement; it must either be reflected in the price, or tied to a representation and warranty, or covered by a specific indemnity provision, or made a condition precedent, or deliberately assumed. The representations and warranties must be read together with the disclosure schedule, and the scope of disclosure must be kept narrow and specific. The indemnity limitations must be structured in a balanced manner as regards the de minimis threshold, the aggregate threshold, the cap and the time limitation. The price adjustment method must be chosen according to the nature of the transaction, and a blocked account or similar mechanism must be provided for as security for collection. The need for merger control clearance must be assessed at the very outset and written in as a condition precedent. Finally, discrepancies in the share ledger and registry records must always be remedied before closing.
Merger and acquisition transactions are closely connected with the other fields of company law. Our article on shareholders agreements, which addresses the contractual framework of the partnership relationship, and our analysis of the liability of board members in joint stock companies, which examines the liability of those serving in company management, address the matters connected with acquisition transactions.
For advisory services on the conduct of legal due diligence, the preparation and negotiation of share purchase agreements, the structuring of acquisition transactions and the resolution of post-transaction disputes, you may contact us at info@guzeloglu.legal.