Due Diligence
Need for Due Diligence
The general principle in purchasing an asset is that the buyer must beware. The default position is that no implied warranties, covenants or conditions whatsoever apply to the purchase of shares in a company.
Contractual provision or provision by way of a deed is necessary if legal assurance is required. For this reason, substantial warranties, and to a lesser extent indemnities, are customarily given by a seller of a company or business who has controlled it, to an incoming buyer with limited or no knowledge of it.
Due diligence is important in assisting the buyer in achieving a proper and complete understanding of the target company, its culture, management operation and arrangements. It is often useful in flagging up possible costs and issues which may arise.post completion.
Where an issue is discovered in the course of due diligence, it may lead to an adjustment in the price or the negotiation of further specific warranties or indemnities. An indemnity may be appropriate in respect to a significant contingent liability, which is out of the ordinary course of expectations.
Due diligence may be required where the acquisition is not an outright acquisition. For example, there may be a merger. The shareholders of the respective merging companies would each wish to satisfy themselves in relation to the value of the shares in the other company.
Scope of Due Diligence
The appropriate scope of due diligence will depend on the circumstances. In some case, the buyer may have considerable knowledge of the target company and / or the industry already. In other cases, it may have limited knowledge of the business. These factors will inform the extent and focus of the due diligence which is undertaken.
Where the buyers are insiders such as managers, less extensive or limited due diligence is required. Warranties are unlikely to be given in such cases, in particular where the shareholders are investors. Limited due diligence may be undertaken when investors are taking shares in a company which has been recently incrporated, for example in a joint venture or similar arrangement.
Logistical and time considerations are important. For example, it may not be economic or there may be insufficient time to undertake an investigation of title to real property. In this case, the seller may give more detailed warranties in relation to property and title matters.
Reasons for Due Diligence
There is obvious value in undertaking due diligence in advance of buying. It is preferable to discover problems, value them, adjust the consideration or simply not proceed than to pursue a legal action for damages for breach of warranty or representation after the event.
There may be considerable delay, risk, professional costs and uncertainty in enforcing warranties. In practice, very few cases are brought for breach of warranty. The cases commonly take many years to go to court and may involve significant and prohibitive expenditure Even if the buyer succeeds, he may not have recourse against a seller with assets sufficient to meet the claim.
Limitation periods commonly apply in respect to warranties. They are commonly shorter than the statute of limitations period. Where issues and liabilities may arise, which are outside the time for making a warranty claim, the buyer effectively takes the risk.
The due diligence may inform the negotiation of the share purchase agreement. If specific issues and risks are identified, clauses may be included which effectively allocate those risks, more commonly to the seller. In some cases, there may be very specific identifiable risks which are the subject of an indemnity. Issues in relation to indemnities and security for them are considered elsewhere.
Relationship with Warranties
The buyer will usually undertake a due diligence exercise. This is an extensive enquiry into the legal, tax, asset, financial, trading and other aspects of the target company that is relevant to its value. The manner in which due diligence and the particular issues that commonly arise in it are handled differ depending on the scale of resources employed, the type of company involved and other specific circumstances.
It might be claimed by the seller that legal due diligence is an alternative to warranties and indemnities. This position is rarely accepted. Many matters that are the subject of warranties are far beyond ascertainment in due diligence. Due diligence may disclose risks that should be borne by the seller, regardless of the fact that they emerge on due diligence
It is accepted in most cases that the legal due diligence does not alter the contractual risk allocation between the seller and buyer. The buyer may forego undertaking due diligence in some cases and rely exclusively on warranties. This will be rare, except perhaps in relation to particular issues.
Most matters discovered on due diligence have no inherent legal effect. They are facts about the company. False or incorrect answers in due diligence may be (at most) representations that do not necessarily carry any liability for breach unless they are fraudulent (reckless or intentional) or (in most cases) negligent.
Relationship with other Elements of Purchase
In most cases, the share purchase agreement is not entered until completion of due diligence. It is possible in principle to have a share purchase agreement which provides for the completion of due diligence to the satisfaction of the buyer. In the normal course, where there is no share purchase agreement or in the unusual case where there is, an agreement subject to the buyer’s discretionary approval of the due diligence process, the buyer may effectively “walk away” at any point in time until completion.
Legal due diligence is usually undertaken in parallel with other types of due diligence by other professionals. At a minimum, there will usually be a financial and tax due diligence which is undertaken by accountants and tax specialists. Many other types of professional advisors may be involved depending on the nature of the business. For example, in the case of a development property company, land surveyors, planning and environmental consultants may be involved.
Extent of Due Diligence
Given the potentially open-ended nature of due diligence, the buyer’s advisors should seek to determine its scope. There should be a cost-benefit approach in using the available resources in investigating legal and other issues concerning the company. The issues that are focussed on, should be those which pose a particular risk in terms of probability and magnitude on the value of the company. Practical and common-sense considerations apply.
In some cases, there may be limited time, opportunity or resources available to undertake a due diligence. In the case of an auction sale where the buyer is competing with other potential buyers, the due diligence process may be circumscribed.
The buyer, solicitor or legal advisor should be instructed in writing as to the scope of due diligence required. It should provide for matters to be communicated. It may be a due diligence report. It is critical to have a common sense, practical and commercial focus on what is required and critical, and what is not.
Due Diligence Organisation and Structure
In many cases, the buyer’s solicitor will co-ordinate legal due diligence. In the case of a larger scale buyer entity, there may be an internal project manager who manages the acquisition including the legal elements.
The buyer may be able to use its own resources to undertake certain aspects of the due diligence in-house, where it is of sufficient scale. Larger entities may have their own tax advisors, accountants and other professionals with skills relevant to the sector concerned. The buyer may retain its own external advisors with specific responsibilities in relation to the acquisition who may undertake a duty of care with the possibility of a professional negligence claim if their duty has not been fulfilled.
The legal advisor who undertakes the due diligence report may report to the buyers or to the advisors who are negotiating the share purchase agreement and agreeing on the terms of the documentation. Issues arising from due diligence should be reflected in the share purchase agreement, tax indemnity other documents as appropriate.
Due Diligence Process
Legal due diligence usually commences with an omnibus legal due diligence questionnaire dealing with a wide range of legal and quasi-legal matter. Often a standard questionnaire in very generic broad terms is used. The criticism is sometimes made that many questions may be irrelevant to the particular circumstance of the company. The buyer should seek to remove irrelevant questions which are potentially onerous to answer and inefficient.
Commonly a data room, now usually in electronic form, will be made available to the buyer The due diligence process may be limited to the information which the seller has made available. It is a matter of market strength and negotiation as to whether further information may be made available. Where there is no competitive process, that buyer may have correspondingly greater negotiating strength.
Where there is a competitive process with a number of possible buyers, the seller may have greater control on the process It will usually use an electronic data room, which is available to each buyer’s authorised advisers. There may be a transparent mechanism for answering enquiries and making the replies known to all bidders. A buyer may seek to reserve the right to pursue additional enquiries. If the seller is willing to accept such a clause at all, it may seek to limit it to particular matters.
Sector and Business Specific
The nature of the target company will determine the type of matters on which legal and other due diligence may focus. For example, a company may have a significant property portfolio from which the value of the company is derived. In this case, title, planning, building control and other matters affecting the property are central.
It may be a business that has a potential adverse impact on the environment, in which event licensing, historical contamination and clean up risks must be considered. It may be a trading company with a limited number of clients and accounts in which event the nature of the relevant relationships and contracts etc may be critical.
Where the company’s value is dependent on the continued involvement of senior personnel, close regard should be had to their contracts. If the value of the company can be easily drained by such personnel resigning (and perhaps even establishing themselves in competition), the issue of employment contracts and other ties as may exist may be critical.
There are limits to the extent to which contracts may tie management and other critical personnel. The restraint of trade itself is not legitimate. The existence of non-solicitation and “non-compete” clauses, to the extent that they are valid, may restrain resignation and establishment in competition, at least in the short run. The personnel are better retained by incentives
Allocation of Responsibilities
In many cases, the documentation which the legal advisors may evaluate may be primarily of commercial significance. It may be beyond the capacity of the legal advisors to understand the commercial significance of the documentation. The legal advisors may seek not to have responsibility for evaluating the commercial significance of information and may provide accordingly in their engagement letter.
Some elements of legal due diligence will overlap with due diligence undertaken by others such as financial advisors, accountants, taxation advisors etcetera. Proper liaison between the legal and other advisors is required, in some cases so that other advisors can properly undertake and assess the legal risks.
In some cases, legal due diligence will prompt the need for further due diligence and investigations. Other experts advise whether experts in particular legal areas or experts in other fields may be appropriate. The legal advisers should advise accordingly.
Warranties about Due Diligence I
The share purchase agreement will commonly provide warranties that refer to the due diligence process. This will provide a contractual remedy in the agreement rather than a remedy based on misrepresentation.
Misrepresentations afford limited remedies only which are dependent on whether the misrepresentation was fraudulent, negligent or innocent. Considerable issues of proof arise. In contrast, a warranty as to a particular matter is usually (depending on its terms) an absolute obligation or undertaking.
The buyer may seek a clause to the effect that there is no matter of fact which should have been disclosed on the basis that it would render other material or information untrue or misleading, which on the basis of utmost good faith ought to be disclosed to an intending purchaser of shares in the company or where its disclosure might reasonably affect the willingness of the buyer to purchase.
The seller, of course, would not wish to warrant in the latter terms given the reasons are self-evident. Equally the buyer would wish to have a warranty on these terms if possible.
Warranties about Due Diligence II
There may be a warranty that the written information and documentation furnished to the buyer and its representatives are true and accurate in all respects. Where they relate to matters of opinion, it may be confirmed that the opinion is honestly held on the relevant date and has a proper basis in fact.
The clause may be resisted on the basis that the warranties particularly in relation to key matters relating to the company they should be specifically embodied in a specific warranty in the agreement.
The scope of the clause may be limited to specified documents so that no allegation can be made regarding other documents which may have been revealed or purported to be disclosed in the course of the due diligence.
Commonly the share purchase agreement will provide that it contains the entire agreement and that all purported representations are negated and have no legal effect.
In the context of due diligence, a confidentiality agreement is usually required in relation to information disclosed. Highly sensitive information may be disclosed. The agreement may not — the matter may not ultimately proceed.