When buying a business, a buyer may be particularly concerned to ensure that they acquire profitable existing contracts which the business has entered into with third parties. The legal framework underlying each method of transfer is very different and the implications for existing commercial contracts varies depending on the choice of acquisition method.
The two most common mechanisms for acquiring a target business are:
A Sale and Purchase Agreement (SPA) will goven the terms of the sale whether the transfer is by Asset or Share acquisition.
The ‘benefit’ of a contract is equivalent to a party’s rights under a contract. This could be the right to payment for goods, or the right to receive goods or services. The contractual ‘burden’ is comparable to a party’s obligations under a contract, for example the obligation to make payment for goods or services or deliver goods pursuant to a contract.
English law provides that the benefit of a commercial contract is prima facie assignable, whereas the burden cannot be assigned freely. The seller will remain liable to perform any obligations which still have to be fulfilled under the contract.
Where ownership of a company is transferred by the acquisition of the entirety or the majority of the shares in a company, the target business is not affected by the transfer. The buyer acquires every asset, liability, right and obligation that the company had prior to the acquisition.
In relation to contracts to which the company is a party, the rights and obligations conferred by the contracts remain unaffected by the change in ownership of the company, i.e. the benefit and the burden remain with the company.
There is one important caveat to this rule, whereby certain contacts contain ‘change of control’ clauses, which allow a party to terminate the contract where there is a change in the ownership of the company.
Where a purchaser acquires the assets required to carry on the business, the SPA will specify which assets and liabilities will be transferred. Premises, plant and machinery, employees and intellectual property must each be transferred in accordance with the specific form of transfer required for the asset.
In relation to contracts, the benefit of existing contracts entered into by the seller will not be transferred to the buyer automatically, as is the case with a share acquisition. Contracts must be transferred to the buyer through either assignment or novation.
An assignment is the transfer of a right from one person to another. Notice must be given to the other contracting party in accordance with s.136 of the Law of Property Act 1925. Without a legal assignment, the third party can continue to make payments to the seller of the business.
Since the seller will remain liable on existing contracts until specifically released by the third parties, in practice, the buyer will usually assume performance of the contract with effect from assignment and the seller will be indemnified against any liability for failure to perform by virtue of an undertaking in the SPA.
Many contracts require the consent of the third party for an assignment of the benefit to be effective. Therefore, the buyer should always check whether or not the terms of a contract prohibit assignment or require the consent of the other party in order to give effect to the assignment.
Novation takes place where the contracting parties agree that the buyer will ‘replace’ the seller. Where a contract is novated, the buyer enters into a new contract with the third party with identical rights and obligations and the seller’s rights are extinguished. The net effect is the same as with an assignment but essentially a new contract has come into existence.
In order to be effective, all parties must agree to a novation. This is usually achieved through the use of a novation agreement, which must be signed by all parties. Consequently, novation can be a time-consuming (and expensive) process if the company has numerous existing contracts.
There are also a number of reasons why third parties could refuse to agree to novation, especially where there has been a long-standing commercial relationship with the seller and there are concerns as to the ability of the new owners to perform to the same standard.
When considering which method of transfer to use, it is important to distinguish between ‘routine’ contracts and ‘fundamental’ contracts. With most minor contracts, a simple assignment to the buyer will be appropriate. Third party consent may not even be required.
Novation is unusual for straightforward contracts, because of the disproportionate amount of time required to obtain the necessary consents. In relation to fundamental contracts, novation may be more desirable and there should be appropriate provisions in the SPA to ensure that the seller will assist with obtaining any necessary consents prior to the transfer.
Share acquisitions are certainly more straightforward in respect of the transfer of commercial contracts, however asset acquisitions do offer more flexibility in that the buyer can specify which assets and liabilities will be transferred.
For specialist advice about contract law, assignment or novation of commercial contracts and the different mechanisms for acquiring a target business, contact Leigh Ellis on 020 7353 1770.
