This guide considers the legal aspects of due diligence from two angles:-
- The process of legal due diligence; and
- The legal issues in general relating to a due diligence exercise.
Due Diligence is carried out by the Purchaser and its advisers and, as such, these notes necessarily concentrate on the Purchaser’s position. However, the Sellers’ perspective is also considered below.
2. Relations with other advisers
The Purchaser’s solicitors will need to be informed of the other professionals with whom they will be working, and the ambit of each of their investigations. They will also need to be told of any due diligence which the Purchaser will be undertaking itself. These are obvious points, but the last thing the Purchaser will want is the duplication of work and costs.
Where more than one professional is involved, it is perhaps inevitable that the Sellers will face requests for the same information from different sources. This can be irritating, but the problem can be avoided by good communications (at the outset and throughout), and the circulation of information between the Purchaser’s different advisers.
3. Why undertake legal due diligence?
A common reaction is that this process will inevitably cost a significant amount and only tell the Purchaser something it already knows. But there are strong arguments in favour of a legal due diligence programme:-
- Prior knowledge is better than litigation;
- Possible discovery of attempts to deliberately conceal information by the Sellers;
- Necessary consents and releases will be identified; and
- Possible discovery of previously unidentified problems.
It is possible for a Purchaser to buy a company relying just on warranties and indemnities and what the Sellers are prepared to disclose to the Purchaser against the warranties in the formal Disclosure Letter. However, if things go wrong, the Sellers have the money, and the Purchaser faces the costs and the uncertainty of bringing its case to court. Litigation can also be time consuming and if the Sellers are individuals who have taken their assets abroad, there can be many obstacles to a successful claim.
It is therefore always preferable to try to identify problems before buying a company, rather than relying on warranty and indemnity claims afterwards. Moreover, prior identification of problems can help identify “deal breakers” early, and also determine the correct price to pay. Due Diligence can sometimes lead directly to a price re-negotiation.
Deliberate concealment of material information is often difficult to discover if the Sellers are determined to hide the information. However, just taking warranties and indemnities without further investigation is unlikely to uncover fraud or other wrongdoing, whereas legal and financial due diligence can sometimes identify suspicious circumstances.
The greater probability is that the Sellers are honest. Most Sellers are so concerned about warranty and indemnity liability that they give painstaking attention to the detail of the warranties and the disclosure process. What is much more likely to come to light are previously unidentified problems. Few companies engage lawyers to review every aspect of their business, and while Sellers may genuinely believe that their company is problem-free and clean, a legal due diligence programme can sometimes uncover legal difficulties which had not been identified previously. It is often not that the Sellers are being in any way dishonest or attempting to mislead, but they genuinely did not have the necessary professional skills to spot the problem.
The parties should recognise that most of the due diligence information will form the foundation for legal liability in connection with the sale of a company or business. Invariably, the information resulting from a due diligence exercise will be put into the Disclosure Letter. This suits the Sellers, because the contents of the Disclosure Letter will qualify the warranties in the Sale Agreement, and exempt the Sellers from warranty liability for the matters disclosed. It also benefits the Purchaser, because the contents of the Disclosure Letter, (including the due diligence information), will normally be warranted as accurate as a term of the Sale Agreement.
4. Can the Purchaser undertake due diligence itself?
To an extent, every Purchaser undertakes some due diligence itself. The key question is whether it should instruct professionals to carry out any part of the formal investigations.
The obvious advantage of instructing a legal advisor is expert knowledge. The Purchaser’s solicitors will have the requisite knowledge to be able to identify any problem which may be lurking and, hopefully, resolve it. Resources are also a factor. An acquisition is a time- consuming exercise for both the Sellers and Purchaser, and the Purchaser may simply not have the manpower to conduct the exercise itself. Drafting in outside professionals will ease the burden on the Purchaser, and leave it to concentrate on essential commercial issues.
5. Why is legal protection necessary?
- Under English law, virtually no terms are implied in favour of a Purchaser of shares in a target company; the principle is “buyer beware“. Consequently, protection must be achieved both by investigation and under the terms of the Sale Agreement.
- Purchasers often mistakenly believe that they can rely on the audited accounts of the target company, such that if those accounts prove to have been negligently audited, then a Purchaser can sue the auditors for any fall in value of the company as a result. However, auditors owe their duties to the company and not any Purchaser of, or investor in, its shares. In the absence of any express representation by the auditors to the Purchaser upon which it was intended the Purchaser should rely, the Purchaser is unlikely to recover damages from the auditors in these circumstances.
- It is a criminal offence for any person to induce another to enter into an agreement for the sale of shares by, amongst other things, any dishonest concealment of material facts. However, oral misrepresentations are notoriously difficult to prove, which is why Purchasers usually seek express written representations (or warranties) in the Sale Agreement.
6. How is Due Diligence conducted?
There are a number of ways of undertaking due diligence. The most obvious is by a personal visit to the premises of the target company. However, wherever confidentiality is a key issue, this might prove difficult. It will certainly need the co-operation of the Sellers and the top management of the target company. Another way is to seek due diligence information through questionnaires and preliminary enquiries obtained from the Purchaser’s advisers. The Sellers and their advisers will be asked to respond to detailed written questions. Whichever procedure is adopted, detailed notes, and wherever possible, copies of any documents examined, should be kept.
7. The Purchaser’s legal obligations on receiving due diligence information
A number of obligations can arise:-
- Duty of confidentiality: In most cases a duty of confidentiality is probably implied by English law in any event, but it is quite often set out in a formal Confidentiality Agreement. A Purchaser who misuses confidential information may face an action for damages and/or an injunction to restrain its unlawful use of that information.
- Specific contractual covenants: These may be contained as separate undertakings in a Confidentiality Agreement e.g. the non-solicitation of the target company’s employees.
They usually bite not during the due diligence period, but also for a stated period after an abortive transaction.
8. Due Diligence: the Sellers’ perspective
There are a number of issues to be considered by Sellers facing a due diligence investigation:-
- Make sure the Sellers’ solicitors are copied with all responses to information requests. From the Sellers’ perspective, the commercial imperative is proper disclosure. It is, therefore, critical that all information which is supplied to the Purchaser or its advisers is also supplied to the Sellers’ solicitors so it can be included in the formal Disclosure Letter. In this respect, personal visits can often be dangerous because the potential Purchaser has access to information which may not necessarily be copied to the Sellers’ solicitor so they can include it in the formal Disclosure Letter. Strict discipline is a must.
- Use code names. If secrecy is important, it can be useful to insist that all parties to the proposed sale use agreed code names. These names can help protect the identity of the parties and the target company should any sensitive correspondence or other written material fall into the wrong hands.
- Strict channels of communication. Where confidentiality from employees is important to the Sellers, then they should insist on pre-arranged channels of communication. Normally these would be via the Sellers or only with top level management of the target company.
- Be disciplined about disclosure; the contents of the Disclosure Letter will normally be warranted. It is tempting for the Sellers to throw as much information as they can into the Disclosure Letter. However, they should be disciplined in this respect, as the contents of the Disclosure Letter will normally be warranted. Statements which cannot be verified properly should be made with caution.
- Confidentiality Agreement. It is always a wise precaution for the Sellers to insist that the Purchaser signs a Confidentiality Agreement at the outset. It is also becoming increasingly common for the Purchaser to require the Sellers to sign a Confidentiality Agreement, particularly in situations where the Purchaser’s future plans are revealed to the Sellers.
- Restrictions on approaches to customers, suppliers, competitors and employees. Much damage can be done if the Purchaser approaches existing and former customers, suppliers, competitors and employees as part of its investigations into the target company. In return for disclosing confidential information to the potential Purchaser, the Sellers might require the potential Purchaser to enter into appropriate restrictions as part of the Confidentiality Agreement.
- The target company may have been investigated already. There are many sources of information for a potential Purchaser of a company. Moreover, skilful private investigators may be able to uncover surprisingly sensitive and confidential information about the target company. The Sellers should not therefore exaggerate about the company’s position. The Purchaser may sometimes know more than the Sellers!
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