Liability for Defects Under Share Transfer Agreements

ABSTRACT

Share assignment agreements, are agreements that change the shareholder structure of companies and produce significant legal and economic consequences for both the buyer and the seller. Defects, namely deficiencies in the legal or economic characteristics of the assigned shares, may lead the parties to disputes. Although the liability for defects provisions regulated under the Turkish Code of Obligations Numbered 6098, in principle, are applicable to all sales contracts, their applicability to share transfer agreements is a matter of debate in legal doctrine. In this article, the legal essence of share transfer agreements is examined first, followed by an analysis of the types of contracts to which liability for defects provisions may apply and lastly, the applicability of these provisions to share transfer agreements is evaluated alongside with a review of recent perspectives and practical examples.

Key Words: Share, Share Transfer Agreement, Company, Joint Stock Company, Liability for Defects, Share Transfer

I.  INTRODUCTION

The share transfer agreement is one of the fundamental legal acts that result in changes in the distribution of shareholdings in companies and, from time to time, may lead to a shift of executive control. Through the transfer of shares, not only the possession of the share but also the economic rights, the management rights attached to the shares, and an indirect economic influence over the company are transferred. Therefore, the legal and factual attributes of the transferred shares, the financial condition of the company, and the scope of the rights conferred by the shares have significant importance for the parties.

In practice, share transfer agreements are generally treated as a sale of rights. However, depending on the scope and character of the transfer, it is acknowledged that the provisions on liability for defects may also apply in certain cases[1]. In this regard, the scope and conditions of application of liability for defects may differ depending on the legal essence of the agreement as well as the extent and content of the transfer. The absence of a clear statutory regulation on this matter has led to divergent interpretations in doctrine and judicial decisions, thereby creating significant uncertainty in practice.

II. LEGAL CHARACTER OF THE SHARE TRANSFER AGREEMENTS

A. Subject Matter of the Agreement

In general, the subject matter of sales agreements may consist of goods, rights, economic benefits with monetary value, or groups of goods and rights.[2] Since a share is regarded as a right in terms of its legal nature[3], it is argued that share transfer agreements are primarily considered within the scope of a sale of rights.[4] In a share transfer agreement, the seller’s obligation is to transfer the company share, along with the rights arising therefrom to the buyer. Within this framework, the fact that a share confers corporate governance and property rights, constitutes part of the capital, has market value, and its assignability renders it an economic asset capable of being the subject matter of an agreement of sale.

B. Nature of the Agreement

There are two main approaches regarding the legal nature of a share transfer agreement. Pursuant to the first view, a share transfer is, as a rule, the sale of a right. In these terms, with respect to liability for defects, the provisions of Articles 219 et seq. of the Turkish Code of Obligations Numbered6098 (“TCO”) on the sale of movables do not apply; instead, Articles 191- 193 of the TCO, which are exclusive to the sale of rights, should be applied.[5] The second view argues that the evaluation should be made depending on the scope and nature of the transfer.[6] In particular, where the shares assigned grant control over the company or nearly the entire company is assigned, it is accepted that the subject of the transfer is effectively the company itself, and therefore, the provisions on the sale of movables should be applied by analogy.[7] Finally, there are also Court of Cassation decisions defining the concept of “share” as “movable property.”[8] In this context, whether a share transfer can be associated with the sale of movables, and thus whether Articles 219 et seq. of the TCO are applicable, is evaluated based on the scope and nature of the transfer, and this issue continues to be a matter of debate in doctrine.

These two main approaches lead to different outcomes in terms of applicable provisions. The first view emphasizes the legal nature of the share and argues the application of the rules specific to the sale of rights, while the second view focuses on the economic and practical effects of the transfer and maintains that, under certain conditions, the provisions on liability for defects in the sale of movables should be applied by analogy. Within this framework, especially in share assigns of an executive nature, the approach adopted becomes decisive for the scope of parties’ rights and obligations and the applicability of liability for defects.

III. APPLICABILITY OF LIABILITY FOR DEFECTS TO SHARE TRANSFER AGREEMENTS

A defect is generally defined as a deviation in a negative sense from the qualities that the sold item should have or has been promised to have; in other words, a deficiency in quality. The institution of liability for defects is fundamentally based on the warranty of conformity theory; according to this theory, the absence of defects in the item sold is an inseparable part of the seller’s duty of delivery. The seller’s primary obligation is to deliver the sold item free from defects or deficiencies in quality. If the seller breaches this obligation, the provisions on liability for defects become applicable.

In this context, Articles 219–231 of the TCO regulate the seller’s obligation to deliver the item sold in accordance with the agreed terms and free from defects. For liability to arise, the item must have been delivered, the defect must be essential, it must not have been known by the buyer, it must have existed prior to delivery, it must not be an obvious defect, and liability must not have been excluded by contract. In addition, the buyer must not have accepted the item in its defective condition.

The institution of liability for defects is not limited solely to sales contracts; the legislator has introduced special provisions for some contracts and accepted the application of sales rules to others by analogy. For instance, in contracts for work, the contractor is obliged to deliver the work free from defects, and in barter contracts, liability for defects arises from the mutual obligations to deliver. Similarly, in share transfer agreements, especially where the transfer ceases to be merely a transfer of rights and effectively takes on the nature of an undertaking of a company, it is argued that Articles 219 et seq. of the TCO may be applied by analogy. Whether liability for defects is applicable to share transfer agreements depends essentially on the approach adopted concerning the legal nature and scope of the transfer. As explained above, since a share is legally characterized as a right, as a rule, Articles 191–193 of the TCO should apply to such contracts. However, if the shares transferred are sufficient to confer control over the company or comprise nearly the entire company, the transaction may be considered economically as a transfer of enterprise, and in such cases, the provisions of Articles 219 et seq. of the TCO on the sale of movables may be applied by analogy.[9]

Although the transfer of executive shares does not legally amount to a direct transfer of enterprise, it effectively results in decisive influence over the company’s assets, activities, and organizational structure. Since the close connection between company shares and the company’s economic existence turns the transfer of such shares into more than a mere transfer of abstract rights, it becomes an act conferring indirect management over the company as a whole. In many cases, the buyer ties the economic benefit to be gained from the shares directly to the existing or expected value of the company’s assets.[10] For this reason, in the transfer of executive shares, defects arising from the enterprise that disrupt the company’s economic integrity or organizational structure directly affect the value of the share and the benefit expected by the buyer.

In such cases, due to this direct relationship between the enterprise and the shares, it would be both legally consistent and equitable for the parties to treat defects in the enterprise as defects inherent in the shares themselves, thereby justifying the applicability of Articles 219 et seq. of the TCO. In conclusion, where a defect in the enterprise disrupts its economic integrity or organizational structure, it should be regarded as a defect in the share itself, and the provisions of Articles 219 et seq. of the TCO should apply to such share transfers, to the extent appropriate.

IV. ADAPTATION OF DEFECT CONDITIONS TO SHARE TRANSFER AGREEMENTS

The provisions of the TCO on liability for defects are essentially intended to apply to the sale of tangible goods, and their direct applicability to transactions involving the sale of rights is limited.[11] Since in share transfer agreements concerning capital companies, the subject matter is the shareholder status along with the rights and obligations attached to it, these contracts are generally considered as sales of rights. The absence of material defects in sales of rights is the main reason why the applicability of defect liability provisions to share transfer agreements is debated.

A. Types of Defects in Share Transfer Agreements

Deficiencies as the source of defects may arise in different ways[12]. As with tangible goods, the concept of material defect here acquires meaning through the company’s physical assets. Deficiencies, defects, or breakdowns in the company’s machinery, production facilities, or inventory that significantly reduce value may be considered material defects insofar as they directly affect the economic value represented by the share transferred.

A legal defect arises when the rights represented by the share are legally restricted or extinguished. The lack of necessary permits for the company’s activities, the invalidation of intellectual or industrial property rights, the existence of encumbrances such as pledges or usufruct rights over the share, or the share’s failure to have the attributes stated in the transfer are examples of this.

An economic defect arises in cases such as misstatements in the company’s financial statements, excessive indebtedness, liquidity shortages, or the failure to achieve promised profits. When such deficiencies directly affect the economic value of the share and the benefit expected by the buyer, the defect originating from the enterprise is considered inherent in the share itself.

Through this adaptation, although fundamentally designed for movables, Articles 219 et seq. of the TCO, can be applied by analogy to controlling share transfers, thereby clarifying the liability regime for both buyer and seller.

B. Conditions of Liability for Defects in Share Transfer Agreements

For Articles 219 et seq. of the TCO to apply to share transfer agreements, the conditions for liability for defects must be adapted to the subject and nature of the contract. Although the direct application of defect provisions designed for tangible goods is limited, deficiencies in a company’s assets and operations can directly affect the value of shares. Therefore, the conditions for liability for defects under the TCO may be adapted to share transfers as follows:

i) Transfer of the share to the buyer: Liability for defects in share transfer agreements generally arises only after the transfer has been legally completed. The transfer occurs upon fulfilment of the formal requirements stipulated by law (e.g., endorsement and delivery of a registered share certificate, registration in the share ledger for uncertificated registered shares, delivery for bearer shares)[13]. Until transfer is completed, the seller cannot be held liable for defects.

ii) Existence of a substantial defect in the transferred share: By substantial defect, it is meant that there are deficiencies in the company’s assets or in the legal status of the share that significantly eliminate or diminish the economic purpose of the transfer. Such deficiencies may include defects in the company’s physical assets (material defect), legal deficiencies in permits or intellectual rights (legal defect), or inaccuracies in financial statements (economic defect).

iii) Unawareness of the defect by the buyer: If the buyer knew of the defect at the time of transfer or could have detected it through reasonable inspection, the buyer cannot hold the seller liable. In share transfers, this often becomes evident during the due diligence[14] process; deficiencies that remain undiscovered despite this process may be treated as defects.

iv) Existence of the defect prior to completion of the transfer: The defect must have existed before the transfer was completed. Deficiencies arising after the acquisition due to the buyer’s actions or external factors should not fall within the seller’s liability.

v) The defect not being obvious: Defects that can be easily detected by simple inspection cannot be invoked against the seller if the buyer fails to notify within the legal timeframe after the transfer. For example, if the company’s concordat status has been registered in the trade registry.

vi) Liability not excluded or limited by contract: The parties may limit or exclude the seller’s liability for defects in the share transfer agreement. However, such clauses must not contravene the principle of good faith.[15]

vii) The buyer not having accepted the defective condition: If the buyer knowingly and explicitly or implicitly accepts the defective condition of the share, they cannot later rely on the provisions regarding defects.

In conclusion, the above elements represent the adapted application of the liability for defects provisions of Articles 219 et seq. of the TCO to the nature of share transfer agreements. Although there is no explicit statutory regulation on this matter, given the characteristics of share transfers and the balance of interests between the parties, these conditions can reasonably be interpreted and applied in this way.

V. CONCLUSION

Share transfer agreements are significant legal transactions that change the equity ownership structure in joint-stock companies and often result in a shift of executive control. The nature of these agreements, the scope of the shares transferred, and their economic effects directly influence the applicable liability regime. Particularly where the transfer ceases to be merely a sale of rights and effectively becomes a transaction conferring control over the company’s assets, activities, and organizational structure, defects affecting the economic value of the shares should not be regarded merely as abstract deficiencies in rights but as deficiencies undermining the integrity of the enterprise.

Although the provisions of the TCO on liability for defects are, as a rule, applicable to the sale of tangible goods, doctrine and case law have advanced strong arguments that these provisions may be applied by analogy in controlling share transfers. This approach is both legally consistent and equitable in terms of maintaining the balance of interests between the parties. Since the buyer often ties the benefit expected from the shares directly to the existing and anticipated value of the company’s assets. Thus, defects originating from the enterprise directly affect the value of the shares and the economic purpose of the agreement.

This study has shown that the conditions for liability for defects under Articles 219 et seq. of the TCO can be adapted and applied to share transfer agreements. Although there is no explicit statutory regulation on this matter, considering the characteristics of share transfers and the legal-economic relationship between the parties, it is possible to apply by analogy the logic underlying the defect provisions for tangible goods. Such an approach will strengthen both contractual security and the principle of commercial good faith.

In conclusion, in share transfer agreements of an executive nature, deficiencies in the company’s assets and operations should be regarded as defects inherent in the shares themselves, and the provisions of Articles 219 et seq. of the TCO should be applied by analog to the extent appropriate. Clarification of this approach through future legislative regulations or consistent case law will be important for eliminating uncertainties in practice.

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