A previous post (in Dutch) discussed a recent case of the Belgian Supreme Court about the nullity of a sale of shares because of prohibited financial assistance. The case giving rise to the judgement of the Belgian Supreme Court illustrates how the nullity sanction is cleverly designed to exploit the incentives of contract parties to serve the legislator’s goals.
The rules on financial assistance come into play if a company advances funds or makes loans or provides security, with a view to the acquisition of its shares by a third party (art. 25 of the Second Directive). A violation of the rules on financial assistance can lead to the nullity of the transaction. As financial assistance is considered to touch upon the ‘ordre publique’ both the seller and the purchaser (or any other interested party for that matter) have standing to claim the nullity.
This type of symmetrical standing to claim nullity is called in the Belgian-French tradition ‘absolute nullity‘. Most grounds for nullity give only rise to ‘relative nullity‘: only the party protected by the rule that has been breached can invoke the sanction (or can choose not to). In case of ‘relative nullity’ standing is allocated asymmetrically. An example of a ‘relative nullity‘ is the purchaser who is the victim of fraud by the seller; the sale is null and void, but obviously only the purchaser can claim such nullity.
Nullity is the nuclear sanction in contract law. The judge will try to rewind the contract: the parties need to be put in the position that they would have been in without the contract. In case of a sale contract that is null and void, the purchaser owes restitution of the purchased goods and the seller will have to return the original sale price.
Two sisters sold shares in two investment companies to a purchaser. As the purchaser didn’t have sufficient funds available to pay the price of the shares, the payment of the purchase price was partially deferred. This allowed the purchaser to pay the price over time with the proceeds of the investment company. So far, so good. As an additional guarantee for the sellers, the investment companies were made jointly and severally liable for the deferred price.
Unfortunately, the financial crisis occurs and wipes out the value of the investments of the two companies. The shares in the investment companies take a dive and the purchaser cannot make good on his obligation to pay the remainder of the price. The two sisters sue the purchaser expecting to get an award for the rest of the price. The purchaser, however, invokes the nullity of the sales contract: the guarantee by the two target investment companies for the deferred payment constitutes financial assistance. Under the legislation prevailing at the time financial assistance was always prohibited. The claim by the sisters comes back to them like a nasty boomerang: the lower court declared the purchase agreement null and void. As a consequence the sisters, instead of getting paid the remainder of the purchase price, had to pay back everything they had already received. Sure: they themselves got back the shares, but those shares had in the meantime become worthless.
It should be noted that the court could have found a violation of the rules on financial assistance without necessarily declaring the purchase agreement null and void. Because of the far-reaching consequences of nullity, the consequences are generally limited to rewinding the illegal parts of the deal. In case of prohibited financial assistance as in the case at hand, the guarantee that violates the prohibition will definitely be null and void. However, courts will often sever the illegal transaction from the deal if they are able to do so without changing the subject matter of the deal. In the case at hand, the lower court could have held the undertaking by the target companies null, without rewinding the sale. The judgment by Belgian Supreme Court does not tell whether this argument was submitted before the lower courts.
The lower court could also have declared the purchase agreement null and void without ordering the restitution of the moneys that had already been paid. The maxim ‘in pari causa turpitudinis cessat repititio‘ gives judges discretion in tailoring the conquences of deal that is null and void. Again the lower court did not use this option (nor do we know if it was invited to do so).
In any event, the purchase agreement itself was declared null and void and full restitution was ordered, giving us a nice – the selling sisters might have a different opinion – example of the economics behind a nullity sanction.
One can say that the beneficiary of nullity sanction has the equivalent of an option with a strike price equal to the original price. In this case the purchaser had a ‘put option’: the right, but not the obligation, to sell the shares to the seller at the original price. This puts a floor under the risk run by the purchaser. If the value if the share is higher than the original price, the purchaser will not put under the ‘put option’. If, on the other hand, the value of the shares goes down, the purchaser will be better off if the puts the shares to the seller at the original price.
The situation of the seller, in case of an ‘absolute nullity’, is the mirror image. The seller has the economic equivalent of a ‘call option’: the right, but not the obligation, to purchase back the shares from the purchaser at the original price. The seller will only use this right if the value of the shares has gone up since the original sale.
Whatever the evolution of the share value, one or another party always has an incentive to use either the put or the call to rewind the deal. Theoretically the deal will always be rewound as in any possible hypothesis one party or another benefits from doing so.
Private law lawyers often speak about the nullity as a powerful sanction. They rarely explain the driver of this power. The robe of the judge has no magic powers if he issues a nullity sanction nor is his gavel more threatening. The power of an ‘absolute nullity’ lies in the design which makes it always interesting for at least one party to pursue a remedy which serves the purpose of the legislator. Parties know this – at least if they know the legal rule, which in case of rules on financial assistance might not always be the case – and will refrain from the transaction giving rise to ‘absolute nullity’. The legislator has in a cheap way delegated the enforcement of public policy to a private party (see also in Dutch here). In case of a prohibition of financial assistance this policy goal is arguably the protection of the company creditors.
“Private vices by the dexterous management of a skillful politician may be turned into public benefits”.
Was the purchaser in the financial assistance case driven by a high minded desire to pursue the public interest of the legislator which prohibited financial assistance? Rather unlikely. But the legislator cleverly exploited the opportunism of the purchaser (“shares go up: I don’t claim; shares go down: I do claim”) to serve a public purpose.
Or as the Anglo-Dutch proto-economist Bernard Mandeville wrote in the 18th century at the very end of the Fable of the Bees: “Private vices by the dexterous management of a skillful politician may be turned into public benefits”.