[According to the Law of Expediency] 71. Essential Mechanism to Prevent 'Hidden Liabilities' in Transfers of Unlisted Stocks

*This content was translated by AI.

As family business succession and SME (small and medium-sized enterprise) mergers and acquisitions (M&A) have increased, transactions involving the buying and selling of shares in unlisted companies have also risen accordingly.

Unlike listed companies, unlisted SMEs provide almost no publicly disclosed information. It is virtually impossible for buyers to independently verify the reliability of financial statements, unpaid taxes, ongoing lawsuits, labor issues, or violations of permits and licenses.

The so-called "representations and warranties" clause serves as a mechanism to bridge this information asymmetry.

The Supreme Court has clearly explained the function of this clause. Its purpose is to allocate economic risks related to uncertain situations and enable adjustment of the purchase price by reflecting post-contractual realized losses, by requiring compensation from the other party when facts differing from those represented or warranted are discovered after contract termination (Supreme Court Judgment 2018. 7. 20., Case No. 2015Da207044).

Notably, this clause does not protect only "those who were unaware." The Supreme Court ruled that even if the buyer was aware of a breach of representations or warranties at the time of contract signing, the seller's liability for damages is not exempted unless there is an explicit clause in the contract excluding such liability or the matter is specifically listed in the disclosure schedule (Supreme Court Judgment 2015. 10. 15., Case No. 2012Da64253).

This ruling carries practical implications for both sellers and buyers. Sellers must either explicitly list known issues in the disclosure schedule or include exemption clauses. The defense that "the other party was already aware" will not hold without contractual basis. Buyers, meanwhile, should not merely reflect risks discovered during due diligence in price negotiations but must also preserve them through specific contractual provisions.

The "scope" of damages is also determined by the contract. In the absence of clauses defining scope or amount, courts determine compensation by calculating either the reduction in the value of the target company's shares held by the buyer, or the difference between the actual purchase price paid and the price that would have been paid had the breach been disclosed. This process involves considerable time and cost for valuation and evidence submission. Simply pre-specifying the calculation method in the contract can significantly shorten the duration of disputes.

Meanwhile, the aforementioned 2015Da207044 judgment held that even if the buyer later disposes of some shares of the target company, this does not substantially affect claims for damages or the calculation of amounts arising from breaches of representations and warranties, absent any special agreement between the parties. This means liability does not vanish merely because the shareholding structure changed after acquisition.

Conversely, expectations not written into the contract are difficult to protect. Recently, the Seoul Central District Court ruled that mere failure of future prospects such as listing or entry into clinical trials does not justify rescission based on mistake, unless the schedule was specifically detailed in the contract and the other party explicitly guaranteed a particular timeline. Optimistic projections exchanged at the negotiation table are legally equivalent to nonexistence if not transcribed into the contract.

Ultimately, in unlisted stock transactions, it is not trust in the counterparty but documents that protect buyers. Contracts must itemize the accuracy of financial statements, absence of contingent and off-balance-sheet liabilities, absence of legal violations and lawsuits, and status of security interests, while also specifying which remedial measures—damages, price adjustment, or contract rescission—apply upon breach. Although it remains common practice to use one- or two-page contracts for small-scale transactions, the costs incurred in disputes far exceed any savings achieved. For those preparing to acquire shares, we recommend undergoing at least a legal review during the stage of converting due diligence findings into contractual language.

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*This content was translated by AI.