Does the buyer of a business who discovers latent defects in the property that makes up the business have any recourse against the seller? Our business lawyers in Québec City and Lévis help you see things more clearly.
Case study
Jean is a mechanic and owns his own garage, Mécanique 123 inc., a joint-stock company he has owned for more than 30 years. He is now selling his business to Carl. The business is made up of various tangible assets, including inventory and the building where the business operates.
A few months after buying the business, Carl, the buyer, notices that the building is sinking, and the engineers conclude that piles must be installed at a cost of $125,000. Carl wonders whether he can bring a latent defects claim against Jean, the seller, to recover the cost.
Asset sale or share sale
When selling his business, Jean can choose to sell the business’s assets or to sell the shares he holds in the business.
Although this choice is generally driven by tax considerations, it has legal consequences, particularly regarding the application of the legal warranty against latent defects.
The case study does not specify whether Jean sold his business through an asset sale or through a sale of the shares of Mécanique 123 inc. Let’s look at the rights of Carl, the buyer of the business, under both scenarios.
Selling the assets of a business
First, let’s look at the scenario where Carl bought the assets of Mécanique 123 inc., to determine whether he has a latent defects claim against Jean, the seller of the business.
The Civil Code of Québec sets out the general principle that, in Quebec, the sale of property automatically comes with a legal warranty of quality. The legal warranty of quality gives rise to latent defects claims and is governed in particular by article 1726 of the Civil Code of Québec, which reads as follows:
1726. The seller is bound to warrant the buyer that the property and its accessories are, at the time of the sale, free of latent defects which render it unfit for the use for which it was intended or which so diminish its usefulness that the buyer would not have bought it or paid so high a price if he had been aware of them.
The seller is not bound, however, to warrant against any latent defect known to the buyer or any apparent defect; an apparent defect is a defect that can be perceived by a prudent and diligent buyer without the need to resort to an expert.
The sale of a business through the sale of its assets is therefore subject to the legal warranty against latent defects. However, the parties to the deed of sale remain free to agree in writing that the property is sold without legal warranty and that the sale is made at the buyer’s own risk.
Returning to the facts of the case study above, if Carl bought Mécanique 123 inc. through an asset purchase, and the sale contract has no clause stating that the property is sold without legal warranty at the buyer’s own risk, the building is automatically sold with the legal warranty of quality, and Carl can sue Jean, the seller of the business, claiming that the building has a latent defect.
Selling the shares of a business
Now let’s look at the scenario where Carl bought the shares of Mécanique 123 inc., all of which were held by Jean, the seller of the business.
In a share sale, the property sold is the shares of the business, not the assets that make it up, such as buildings, goods, equipment, etc. As the courts have noted, the nature of the property sold (shares) makes the concept of legal warranty difficult to apply.
The De Leeuw case (1991)
The case law specifies that a company’s shares are incorporeal property, in other words, intangible. In 1991, in De Leeuw v. Caisse populaire Notre-Dame-de-Québec, 1991 CanLII 3454 (QC CA), the Quebec Court of Appeal described a share in a company as follows:
“[…] a share is incorporeal property, or rather a movable right, a kind of “interest” in the company that is neither that of an owner nor that of a creditor, but rather one, measurable in money, that confers on the shareholder certain rights or interests by law and under the terms of a contract.” (our translation)
According to the case law, the incorporeal nature of shares is therefore a poor fit with the concept of the legal warranty against latent defects, which aims to hold the seller liable for a material loss of use of the property sold. A share that is sold cannot really suffer a material loss of use because it is, precisely, incorporeal and intangible.
As the Court of Appeal taught in De Leeuw, by buying shares, the buyer acquires a kind of interest in the business. The buyer will not be deprived of the use of the share if an asset of the business transferred through the share sale has a latent defect.
No legal warranty for shares
Building on the Court of Appeal’s reasoning in De Leeuw (1991), the courts, notably in Beauregard v. Kovac, 2009 QCCQ 5576, and Villa Royale inc. v. Roy, 2016 QCCS 5571, have dismissed latent defects claims brought by buyers who acquired businesses through a share purchase.
Overall, these decisions confirm that the law is now clear. Unlike a buyer who acquires a business by purchasing its assets, a buyer who acquires a business by purchasing its shares cannot sue the seller if they later discover that one of the items of property making up the business has a latent defect.
To settle the debate once and for all, the Superior Court stated in Villa Royale inc. v. Roy, cited above:
“In so doing, since it is incorporeal, a share of a company cannot have a latent defect, because the warranty of quality is designed to ensure the usefulness and use of the property. Both the case law and legal scholars have ruled out applying the rules of the warranty of quality to such securities.” (our translation)
Returning to the facts of the case study above, if Carl bought Mécanique 123 inc. through a share purchase, the sale is not subject to the legal warranty of quality, and Carl cannot sue Jean, the seller of the business, claiming that the building has a latent defect.
Contact us
If you are thinking about selling or buying a business, the professionals at Verreau Dufresne Avocats can guide you with skill and efficiency. Contact us today.
Note: The information above is general in nature and does not constitute legal advice. For advice on your particular legal situation, feel free to contact one of our lawyers in Québec City or Lévis.
