In case of high-value real properties even the professional property investors should consider to take out title insurance

It is not yet widespread in Hungary, although common practice in Anglo-Saxon areas, that at the same time of purchasing a real property of higher-value, principally commercial and industrial ones, or a company owning the real property, buyers take out the so-called title insurance. What does this mean in practice? It will be summarized in the following article of the Kapolyi Law Firm.

By taking out title insurance, the buyer passes on to a third party, i.e. to the insurance company, in return for the payment of the insurance premium specified in the insurance contract, the risk that the title to the real property or the company owning the said property has been damaged, which limits or prevents the buyer from acquiring ownership thereof. In this case, according to the terms of the insurance policy, the title insurer indemnifies the buyer for the incurred damage. The question rightly arises that in Hungary, where the land registry is considered as an up-to-date, authentic public register, and the business register also provides comprehensive, reliable information, what hidden risks may arise, i.e. why may it be necessary to take out title insurance? The issue is further toned by the fact that, before purchasing a commercial or industrial real property of higher-value or the company that owns it, the buyer almost always entrusts a law firm before concluding a sale/transfer agreement in order to filter out all the legal risks associated with the real property/company and to identify any factors that may prevent or limit the buyer’s unencumbered acquisition of rights over the property/company. The buyer may, in the light of the risks identified, decide to enter into the transfer agreement on unchanged terms or for a possibly reduced purchase price, or with additional collateral included in the agreement. However, the buyer may also choose not to enter into the transaction.

Kapolyi Law Firm has been in a number of cases required by title insurance companies to assess the potential risks for the buyer (and indirectly for the insurance company) related to the sale and purchase of a real property of higher-value or the shares of company owning the property. Based on our experience in this field, we believe that although title insurance is primarily taken out by foreign investors who are new entrants to the Hungarian market and, therefore, do not yet know the relevant Hungarian legal provisions and official procedural rules, title insurance may still be justified for knowledgeable investors, too. Naturally, buyer’s risks are different when buying the real property itself (“asset deal”) or acquiring the company that owns the property (usually for tax optimization purposes) (“share deal”).

Generally, in the case of purchasing a real property, the authentic land register and the title deed of the real property – in general – provide reliable and complete information about the ownership and encumbrances of the real property or the litigations related thereto. Authenticity and reliability are ensured by the relevant provisions of the Civil Code and the Land Registry Act, according to which the ownership right on the real property as well as certain rights of third parties thereon (e.g. mortgage, call option right, pre-emption, judicial enforcement, easement rights, etc.) are created by the entry into the land register. This means, on the one hand, that before registration the competent land registry office checks the legality of the documents submitted, i.e. it exercises a certain degree of control over the contractual documentation. On the other hand, a real property is only encumbered by the encumbrances that have been registered/recorded in the land registry, basically. An important exception may be, however, the pre-emption right of third party that is based on law (e.g. in the case of many real properties located in Budapest, where the competent district municipality, the Budapest Municipality or the Hungarian State disposes on pre-emption right by law); this pre-emption right exists regardless of the land registry entry. Since a sale and purchase agreement concluded in breach of the pre-emption right may be challenged by the holder of the pre-emption right, the buyer may lose the ownership on the real property even if he had already paid the purchase price.

The situation is less clear, however, if the buyer does not purchase the real property itself but acquires partial or exclusive shareholding in the company that owns the real property. The vast majority of Hungarian companies operate as limited liability companies, therefore, in case of share deals, the buyer acquires the shares of the target company that owns the real property. However, the business register and the business register entry does not provide the same level of protection and real picture on the rights related to the business shares as the land registry does on real properties. In case of the transfer of a business share, the competent court of registration registers the change of ownership on the business share on the basis of the corporate documents submitted by the management of the target company. In this procedure, therefore, the court of registration does not examine the contract on the transfer of the business share; it carries out the above described control only for the corporate documents, but not for the contract on which they are based. It is rather the responsibility of the management of the target company to be acquired to examine whether the share transfer complies with the legal requirements. For example, whether the agreement on which the transfer is based has been duly signed or it contains any provision that may breach any legal prohibition. The management of the target company is also responsible for keeping the updated members’ list and notifying the court of registration on any changes made in the target company. Accordingly, it may imply a serious risk to the buyer if the management of the target company did not perform the above tasks in any previous change of ownership or did not exercise it with due diligence.

Due to the above, it is not revealed in the procedure on the registration of the new owner if the agreement on the share transfer suffers from an error which invalidates the transfer; therefore it might be very important in the case of a share deal to request and examine the share transfer agreements concluded after the establishment of the target company. In addition to the above, the business share may also be encumbered with contractual obligations (e.g. call option right, pre-emption right) that cannot be identified from the company register at all. Therefore, in order to offset his risks and exposure, the buyer, in practice, requires in the share transfer agreements highly detailed and extensive warranties from the seller on the fact that the share is free and clear of all liens, claims and encumbrances. Unfortunately, however, even a highly sophisticated and strict warranty structure might not provide sufficient security for the buyer if the business share is encumbered with unknown encumbrances or the transfer of the business share does not take effect due to a fault in the transfer chain. For example, when, as a result of the possible invalidity of a previous share transfer agreement, the beneficial owner of the share is not the seller. In many cases, however, investors focus mainly on tax optimization factors and “lose sight” of the financial and legal risks outlined above when deciding whether to acquire the given real property through an asset deal or share deal.

It is important to emphasize that even the authenticity of the land registry and business register, the proper legal due diligence of the real property or the company owning it, and the sophisticated warranty structure included in the sale and purchase/transfer agreement do not preclude a third party from challenging the sale/transfer agreement before court claiming the invalidity of a provision thereof. For example, a liquidator may challenge the agreement previously concluded by a company under liquidation on the ground that the seller under liquidation sold its real property at a purchase price that was significantly lower than the actual market value of the real property. Enforcing the buyer’s warranty claims can also be an extremely long, lengthy process if the seller does not cooperate with the buyer who has suffered damage. The buyer must prove that the seller has breached any of the warranties undertaken by the seller and the buyer must prove the extent of the damage resulting from the breach of the warranty, too.

The institution of the title insurance mentioned in the introduction might be a good guarantee for the uncertainties outlined above. The insurance company may indemnify the buyer, among other things, if the transferor of the real property/business share was not the legal owner thereof, the real property/business share is subject to unknown mortgage, call option right, pre-emption right or other third party’s rights, or the transfer of the real property/business share is invalid due to any transfer restriction. Title insurance can also be used in other cases. On the one hand, if due to the invalidity of a previous transfer agreement (e.g. a not dully signed agreement or an agreement signed without the approval of the general meeting), the transfer chain that apparently leads to the seller is not unbroken and therefore a third party may have a stronger title on the business share. Or, if the contractual or corporate documents related to the transfer of the business share are incorrect, and, therefore, the transfer cannot be registered into the business register. Title insurance can also be an appropriate tool for protecting the investor from damages arising from risks known or unknown to him (e.g. fraud, counterfeiting, invalid representation). By taking out the title insurance and paying a certain fee, the buyer can essentially outsource his risks, avoid higher losses and lengthy legal proceedings.