In the investment climate that has applied during the last years, venture capital investors have the upper hand in funding negotiations and have become more selective in their investment selection processes. As a result, investment processes often take longer and investors are conducting more thorough due diligences. Furthermore, investors are requesting more information about target companies and request solid representations and warranties. In this climate it is important to pay attention to some features of Swedish company law that limit investors’ abilities to claim compensation from the target company.
Certain representations and warranties regarding company information (such as accounts, corporate documents and other similar information) provided to a venture capital investor are usually a condition for an investment in a limited liability company. Swedish corporate legislation has, based on legal policy considerations, historically prioritised protection for companies’ creditors rather than protection for other stakeholders. Consequently, it is highly uncertain whether a target company could provide representations and warranties in a new share issue or similar situation, despite the subscription agreement demonstrating significant similarity to other types of agreements in which the company is able to provide representation and warranties.
Since both fundraising and the protection of creditors are important for a well-functioning limited liability company, it is not entirely obvious that the limited liability company structure benefits from the company’s creditors being protected, in many cases, at the expense of other parties such as the subscribers. There have also occasionally been proposals to implement the principle that a company should be liable for any information provided to its investors in annual reports, prospectuses or other comparable documents. The main rule in Sweden, however, is still that a limited liability company’s representatives (i.e. CEO, board members and auditor), but not the company itself, may be liable for incorrect or false information under certain circumstances. The background to this is a ruling from the Swedish Supreme Court back in 1935 in which the Supreme Court ruled that the limited liability company in question could not be held liable in relation to a share subscriber. There is no more recent case that deals with this exact same question, but the matter has been debated in legal doctrine and the general opinion is still that it is not possible for a limited liability company to assume liability in relation to its share subscribers. However, some authors argue that it would be possible provided that the company’s liability is capped at its non-restricted equity, while others claim that the company could provide unlimited representations and warranties.
In this climate, it is important to find mechanisms so that venture capital investors feel comfortable about their investment despite a target company not being able to provide any representations and warranties. In order to satisfy an investor, it is possible to insert different types of clauses in a subscription agreement governing an investment. One alternative for subscribers and companies that is commonly used is the insertion of a recalculation mechanism, entitling the investor to subscribe for additional shares at the quota value should the information provided by the company or the other shareholders prove to be false or incorrect.
Another option is for the other shareholders in the target company to provide representations and warranties in the subscription agreement. Depending on the ownership structure of the target company, the various owners might have different incentives to provide such representations and warranties. It is more plausible that shareholders in companies with only a few shareholders, where the shareholders have thorough knowledge about the target company, would be willing to provide representations and warranties given that the incentives are often greater for such shareholders. Conversely, shareholders in companies with a widespread ownership structure, in which the shareholders do not have detailed knowledge about the target company, are unlikely to be willing to provide representations and warranties.
It is highly unlikely that the CEO, board members or management of a target company would be willing to issue any kind of representations and warranties unless they are also major shareholders. This is mainly due to the non-existent incentives and the risks associated with providing these. In cases where the management or board members are majority shareholders, the board members or management would, perhaps, provide representations and warranties. In this case, such individuals would most likely prefer to provide the representations and warranties in their capacity as shareholders rather than in their capacity as directors/members of management.
Based on the above, it is of utmost importance in an investment situation that an investor considers and evaluates both the representations and warranties and the party that has provided the representations and warranties. An investor must be aware that the target company itself can probably not be held liable for breaches of representation or warranties with legally binding effect and the investor should therefore always endeavour to also obtain representations and warranties from other parties.