Landmark decision by the German Federal Court of Justice on disclosure duties in real estate sales – relevant to entire M&A practice
In certain cases, a seller is subject to a separate disclosure duty even if the buyer has had the opportunity to take notice of a certain issue in a data room. This applies in any case if such issue may cause the buyer considerable financial loss and is not readily recognisable from the data provided. In particular, the buyer may usually expect to be informed by the seller if the seller is aware of the issue and can therefore easily disclose it.
In its judgment of 15 September 2023 (V ZR 77/22), the German Federal Court of Justice (Bundesgerichtshof) further clarified its case law on a seller's pre-contractual disclosure duty and commented on the requirements for the disclosure of documents and information in electronic data rooms. The Federal Court established that disclosure in a data room suffices to satisfy the seller’s disclosure duty if and to the extent that, based on the actual circumstances, the seller may reasonably expect the buyer to take note of the issue that is subject to a disclosure duty by inspecting the data room. In case of doubt and if it is apparent to the seller that the issue in question is of considerable importance to the buyer, the seller has to inform the buyer separately.
The decision is highly relevant to preparing and executing transactions in all economic sectors.
In the context of a commercial property sale in 2019, the seller made several representations in the sale and purchase agreement, including that the seller had no knowledge of any extraordinary costs in the current financial year or in the future and that the owners’ association had not resolved to make any further special cost allocations. The agreement also included a clause stating that the minutes of all owners’ association meetings in the last three years had been made available to the buyer.
Prior to the notarisation, the seller set up an electronic data room with various documents relating to the property to be purchased. On a Friday, three days before the notarisation on the following Monday, the seller uploaded to the data room a collection of documents reflecting decisions taken at owners’ association meetings since 2007. Among these documents were the minutes of an owners’ association meeting in 2016 according to which the owners decided to claim payment of EUR 50 million from the majority owner at the time due to extensive alterations to the jointly owned property. However, the originally contemplated special cost allocation payable by the owners of the commercial units with an indemnification of the condominium owners was rejected. To enforce such a special allocation, another owner brought an action. The proceedings were terminated by mutual agreement in January 2020, with the parties agreeing on a special allocation of initially EUR 750,000 to be paid by the owners of the commercial units for the refurbishment measures, including an option to increase this special allocation to up to EUR 50 million if necessary. As the new owner of the commercial unit, the buyer was obliged to bear a proportion of the special allocation.
In the course of the legal dispute, the buyer claimed not to have been adequately informed about the risk of a special allocation of up to EUR 50 million, to which the buyer as the new owner would be required to contribute proportionately. The buyer pointed out that the minutes of the owners’ meeting held in November 2016 had been “secretly” placed in the data room in an attempt to literally “slip it by” him. The seller argued that the buyer had not made sufficient use of the opportunity to enquire and ask questions and that, at the time when they entered into the agreement, no special allocation had been decided.
C. The Federal Court’s decision
While the lower courts had dismissed the action, the Federal Court established that, due to the considerable importance of the potential costs of EUR 50 million in the case at hand, the seller had a responsibility to separately inform the buyer about the possibility of a special allocation of this amount. According to the Federal Court, issues with the potential to frustrate the contractual purpose or to cause considerable financial loss and which are therefore relevant for the decision to purchase have to be disclosed by the seller not only in the data room; the seller has to expressly advise the buyer of them. This applies at least in an individual case where the seller cannot reasonably expect the buyer to gain knowledge of a certain issue by inspecting the data room. The Federal Court did not accept the formal argument that a special allocation did not exist at the time the agreement was entered into and that it was only introduced by the settlement agreement in January 2020. The Federal Court based its decision mainly on the existing risk of such a special allocation: Since the issue of a special allocation had not been finally resolved, there was a real risk for the buyer, as the new owner, of having to bear a share of the costs for outstanding refurbishment measures, especially if recourse for the costs from the former majority shareholder were to be unsuccessful. The Federal Court was of the opinion that the seller had to separately advise the buyer of this issue.
Duty to disclose despite existence of a data room
The Federal Court first analyzed, without an unequivocal result, the question of whether the establishment of a data room and the performance of due diligence results in the satisfaction of the seller’s duty to disclose. In this context, the Federal Court focused on whether and when a buyer may be reasonably expected, based on the circumstances of the individual case, to notice an issue subject to a disclosure duty in the course of its due diligence. According to the Federal Court, it may not be generally concluded solely from the fact that a data room has been set up and due diligence has been carried out, i.e. that the buyer has been given the opportunity to take notice, that a buyer will become aware of the issues subject to a disclosure duty. This depends on the volume of the data room and its organisation, the correct designation of the documents and systematic sorting and, for example, also whether the buyer is advised of documents added subsequently. According to the Federal Court, it is also decisive how much time the buyer has to examine the information. Finally, it also depends on the form of the information from which the issue subject to a disclosure duty is to be ascertained. As an example, the Federal Court cites the handing over of financing documents or a folder with documents on the property to be purchased. In such cases, a seller may not simply assume that the documents handed over will be checked for defects.
Material significance of the issue that must be disclosed
The decisive factor is the significance of the issue subject to a disclosure duty. If the issue is of material relevance for the decision to purchase, for example because it may frustrate the contractual purpose or cause considerable financial loss to the buyer, the seller is subject to a disclosure duty. If, in addition, this significant issue is not readily apparent from the documents made available, the seller must provide information without being asked despite the existence of a data room and the due diligence carried out by the buyer. This applies in particular if it is not difficult for the seller to disclose the issue and to advise the buyer accordingly. In such cases, the seller cannot rely on the buyer’s being able to ascertain the issue from the documents independently.
Late posting of documents in a data room
In the case at hand, the Federal Court did not consider the seller's disclosure duty to have been fulfilled by posting the relevant minutes of the owners' association meeting in the electronic data room three days before the notarisation. The Federal Court holds the view that there is no reason for a buyer to check the data room for new documents three days before the notarisation without separate notice. It is interesting in this context that the Federal Court holds that a buyer does not have to expect that information will be provided with so little advance notice even where no deadline for the posting of documents in the data room has been agreed. Finally, the issue subject to a disclosure duty was also not readily apparent from the posted documents, as the posted collection contained all resolutions since 2007.
Duty to enquire vs. duty to disclose
The facts on which the decision is based raise the question whether it was possible for the buyer to identify sufficient indications of the potential special allocation. This could result in a duty of the buyer to make enquiries, from the violation of which, however, the Federal Court does not deduce any direct effect on the disclosure duty. In the Federal Court’s view, a failure to enquire would only constitute contributory fault for the occurrence of the damage.
D. Impact in practice
The Federal Court's ruling once again makes it clear that the mere posting of information and documents in a virtual data room is not sufficient to reliably fulfil a seller's disclosure duty and thus exempt the seller from liability. If information is posted in the data room that is of significance for the decision to purchase, a seller should not rely solely on the fact that the buyer will independently identify all information in the course of its due diligence, even if this should usually be the case with the assistance of professional advisors.
In order to avoid possible disputes, sellers must carefully examine and analyse, with the help of professional advisors, which information may be of significant relevance to a potential buyer in the run-up to the transaction and when organising and filling the data room. Such information should be entered in a well-classified and professionally organised data room with unequivocal designation. In addition, potential buyers should be separately advised of any issues that may be of considerable importance for the buyer, and this should also be documented in the sale and purchase agreement, which should also contain provisions on the depth and scope of the due diligence carried out.