Cross-liability

Are you planning to purchase a company that has recently undergone a transformation? You should be aware that such an acquisition may conceal unexpected legal and financial obligations. One of the most significant risks is cross-liability between the companies involved.

In this article, we will explain what cross-liability entails, what risks it poses to the buyer and, most importantly, how to protect yourself against it. The aim is to provide clear information so that you can assess the risks reliably and in advance and take the appropriate steps – such as due diligence – before the acquisition itself.

Author of the article: ​ARROWS (Mgr. Jan Medek, office@arws.cz, +420 245 007 740)

What is cross-liability in company transformation?

Cross-liability is a legal institution that comes into play when a company undergoes a transformation – typically a division (spin-off or split) and, in some form, other types of transformations. It is a legal liability between the companies involved, established by law to protect creditors. In simple terms, the original (divided) company guarantees the debts that were transferred to the newly formed successor companies as part of the division, and conversely, each of the new successor companies guarantees the debts that were assigned to other successor companies during the division or remained with the original company. This ‘cross-liability’ ensures that all companies involved in the transformation (especially in the case of a division) are also liable for the obligations of the other companies involved, to the extent specified by law.

Importantly, this liability is not unlimited: the law sets a limit on cross-liability. Each participating (in particular successor) company is liable jointly and severally (solidarily) with the others for the debts in question, but only up to the value of the assets allocated to it in the transformation according to the plan (typically according to an expert opinion in the case of a division). In other words, the liability is limited to the amount corresponding to the value of the assets that the company acquired in the transformation. This limitation prevents one company from being disproportionately liable for the debts of others beyond what it received from the transformation.

Why did the law introduce such a guarantee in the first place?

Let us imagine, for example, a division of a company in which most of the assets are transferred to a new company and the original company is left with mainly debts. This would significantly worsen the position of creditors – the debtor (the original company) would suddenly not have enough assets to pay its liabilities. In order to prevent transformations from being abused to ‘siphon off’ assets from indebted companies at the expense of creditors, the law introduced the institution of cross-liability.

The purpose is to ensure that creditors' chances of getting paid remain similar before and after the transformation of the company. Creditors can thus claim repayment of the debt even after the transformation from another company of the former entity if their original debtor (e.g. the divided company) no longer has the means to pay. Cross-liability applies both to debts existing at the time of the transformation and to debts identified after the transformation, provided that they arise from activities prior to the transformation – typically, these may include additional tax arrears for the period prior to the division.

When does cross-liability arise and who does it apply to?

Cross-liability is most commonly encountered in the division of a commercial company (in the form of a spin-off or split). In a division, the original company transfers part of its assets to one or more new successor companies, which results in the division of liabilities (debts) among several entities. Cross-liability then links the fate of these entities – the law stipulates that each successor company is liable for debts that, as part of the division, have been transferred to another company or have remained with the original company, up to the value of the acquired assets. Similarly, the original divided company is liable for the debts that have been transferred to the successor entities. This principle applies automatically by law, so no special agreement is required – it arises directly from the Act on Company Transformations (No. 125/2008 Coll.).

How can you tell if cross-liability applies to your target company? A simple clue is to check the commercial register. In the commercial register (in the collection of documents or in the history of records), you will find information about any transformations of the company. If you find that the company was involved in a transformation, in particular a division, then there is a high probability that it bears cross-liability for some of the debts within this transformation.

This fact is not always apparent at first glance from the financial statements – it may be a hidden obligation that does not become apparent until one of the creditors begins to enforce a claim against another company involved. It is therefore necessary to search the company's history and legal documents related to the transformation.

What is the risk for the buyer? (Why be vigilant during an acquisition)

Cross-liability can have very unpleasant consequences for the buyer, whether an investor or owner. At first glance, the company being acquired may appear to be financially sound – it has a clear list of assets and liabilities, valuations, financial statements, etc. However, if it has been part of a transformation, it may be at risk of having to pay the debts of another company with which it was previously connected. Below are the main risks and impacts that cross-liability guarantees pose for the buyer:

Hidden debts and liabilities: Cross-liability guarantees effectively mean that the acquired company may be liable for debts that originally belonged to another company. These debts often do not appear in the accounts of the acquired company because they were allocated elsewhere during the division. Nevertheless, in the event of non-payment by the original debtor, creditors may demand payment from your new acquisition. This can unexpectedly turn a clean company into one burdened with foreign debt.

Financial losses and additional costs: If you find yourself having to pay someone else's debt under a cross-guarantee, this is an unplanned expense that directly reduces the value of your investment. These can be significant amounts – imagine that another part of the originally divided company fails to repay a debt in the millions and the creditors turn their attention to your company. In addition, resolving such a situation itself entails additional costs, such as legal fees or costs associated with court or arbitration proceedings if the dispute goes to court.

Legal uncertainty and reputational risk

Being a guarantor for someone else's debt can lead to legal disputes and protracted negotiations with creditors. For a new investor, this means diverting attention from business to resolving past problems of third parties. At the same time, your company's reputation may suffer – business partners or banks may view a company with the threat of guarantee obligations more cautiously.

Reduction in the value of the company and the buyer's negotiating position

Once a cross-guarantee is discovered during due diligence, it will have a negative impact on the market price of the company. High cross-guarantees are often a reason for reducing the purchase price of a company during an acquisition. The investor will logically demand a discount or other guarantees if there is a risk that they will have to pay someone else's debts in the future. In extreme cases, they may withdraw from the acquisition altogether if they consider the risk unacceptable. (After all, the results of thorough due diligence can significantly reduce the price of the share or even thwart the entire project if such serious problems are discovered.

How to protect yourself from cross-guarantee risks in acquisitions

The good news is that the risks associated with cross-guarantees can be minimised to a large extent if you pay sufficient attention to legal due diligence and preventive measures before concluding the acquisition agreement. Modern B2B practice dictates that these steps should not be underestimated, especially when it comes to investments in the millions.

So how can you avoid being caught off guard by cross-liability? Here are some key recommendations:

Check the company's history

Before you buy a stake in a company, thoroughly research its past. Find out whether the company has undergone any changes, such as a merger, division or transfer of assets. This information can be found in public registers and documents (notarial deeds of transformation, division plans, etc.). As already mentioned, check the commercial register – if you find that the company has been involved in a division (spin-off), be alert. This is the first sign that further investigation is needed.

Analyse the contracts and documentation relating to the transformation

If a transformation has taken place, request all documentation – the transformation plan, expert opinions, final financial statements, etc. These documents will tell you how the assets and liabilities were divided between the individual successor companies and who is responsible for which liabilities. Pay particular attention to what debts remain ‘elsewhere’ – these could fall under cross-liability. For example, if the division project states that a certain loan has been transferred to another successor company, this is a warning sign – your target could be liable for that loan.

Perform legal and financial due diligence

Do not rely solely on your own assessment – hire experienced professionals (lawyers, forensic accountants or tax advisors) to perform due diligence on the target company. They have the know-how to look for potential problems. Legal review will reveal, among other things, the existence of cross-liabilities or other legal defects in the share. For example, a lawyer will check internal documents to see if the company has any other hidden liabilities that are not recorded in the accounts, or if anyone has made a claim against it based on a guarantee for another company's debt. The output of due diligence is usually a detailed report highlighting all risks – this information is essential for further decision-making as a buyer.

Who can you contact?

Address the risk contractually

If the review reveals that cross-liability is indeed a risk (e.g., the company has been split up and there are outstanding debts at a ‘sister’ company), incorporate this into the acquisition agreement. Various protection mechanisms can be negotiated, such as a reduction in the purchase price (reflecting the potential liability), escrow (part of the purchase price will be temporarily withheld to cover any debt), or declarations and guarantees from the seller that no such debts exist and that they will compensate you if they do.

The contractual arrangements should motivate the seller to bear financial responsibility in the event of damage arising from cross-liability, rather than you as the buyer. Of course, it is essential that these agreements are precisely formulated – again, a legal advisor can help with this.

Consult your plan with experts: Every acquisition is unique in its own way. An experienced lawyer specialising in commercial law and transactions will help you identify the specific risks of your particular purchase. Not only will they point out cross-liabilities, but they will also assess other legal aspects (e.g. ongoing disputes, intellectual property protection, labour law issues, tax implications, etc.). Working with experts will give you the confidence that you won't overlook anything important. You can then make an informed decision on whether to proceed with the acquisition and, if so, under what conditions.

Conclusion: Trust, but verify, or don't underestimate legal due diligence

The acquisition of a company that has undergone a transformation can be an attractive investment opportunity – these are often restructured companies that may excel in a certain part of their original business. At the same time, however, the old rule applies: trust, but verify. Cross-guarantees represent a significant risk that no responsible investor should ignore.

Fortunately, as we have shown, there are ways to protect yourself: careful due diligence, consultation with lawyers and thorough review of contractual terms will enable you to manage these risks.

If you are considering purchasing a company after a transformation, do not hesitate to contact our experts. We will be happy to help you examine all the pitfalls, including cross-liability, and ensure that your business decision is based on solid foundations. This will allow you to enter into the new acquisition with confidence that you will not face any unpleasant surprises in the future in the form of foreign debts on your shoulders.

Your business will thus stand on a solid foundation and you will be able to focus on its development, knowing that you have identified the risks in good time.

Remember

Taking over a company is a big step, so it pays to do it with caution and with your back covered. Cross-guarantees are just one example of why it pays to have an experienced legal partner at your side. Don't leave anything to chance – a well-informed and prepared buyer always has a head start when it comes to risks. Your future self (and your company accountant) will thank you for it.