M&A DIRECTIONS PUBLICATIONS SERIES 31 May 2017 M&A Directions: Getting the most out of your M&A Legal Due Diligence

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In this instalment of M&A Directions, we look at how you can get the most out of your M&A legal due diligence. We provide some practical tips on how to approach legal due diligence, how to manage the due diligence process and how to use the results of legal due diligence in the negotiation of transaction documents.

Why are you doing legal due diligence?

Buyer beware!

The traditional answer to this question is ‘caveat emptor’ or ‘buyer beware’. In most common law jurisdictions, a seller of shares or a business is not under any general duty to disclose all relevant information to the buyer. It is the buyer’s responsibility to conduct its own investigation. The general law does not, in the absence of any fraud or misrepresentation, provide protection to a buyer who later discovers that the business it bought is not what it had understood it to be. Due diligence gives the buyer a degree of comfort about what it is buying and how much it might be worth.

What are you buying?

If it is a complex business, understanding what you are buying requires a good deal of investigation and analysis. At a basic level, the purpose of due diligence is to investigate or confirm whether what you are buying is what you expect.

Are you buying what you think? To answer this question, you may need to understand the material legal contracts, assets, licenses and permits, compliance history, intellectual property rights, employees and business practices of the business and any potential challenges.

What are the liabilities of the company you are buying? You will need to understand the actual, potential and contingent liabilities of the company which may arise from, for example, material contracts, financial instruments, taxes, employees, pensions, litigation and disputes.

How much is it worth?

Buyers often value a target company using a market based multiple of EBITDA (earnings before interest, taxes, depreciation, and amortisation) or a present value model, such as discounted cash flows or discounted residual income. Legal due diligence can provide further useful information on what events have affected historical earnings or what events may affect future projected earnings, cash flow or residual income. This due diligence information may be helpful to the buyer in building a more robust valuation of the target business.

Using information as a bargaining tool

Due diligence findings can often be used as an important bargaining tool. This is particularly so when the seller has presented a rosy picture of the business, emphasising its successes but not paying enough attention to its potential faults, in order to justify a high asking price.

If the buyer is able to uncover potential issues or challenges with the revenue model of the target business, or hidden liabilities which have not been fully disclosed, this information could be a useful tool in negotiating a lower purchase price.

What do I need to do to close this deal?

Aside from the questions ‘what am I buying?’ and ‘how much is it worth?’, a very important question to ask is ‘what do I need to do to close this deal?’.

To answer this question you would need to understand the effect of a change in ownership of the company on its material assets and liabilities. Are there change of control provisions in material contracts which would allow the counterparty to terminate the contract if the M&A transaction is completed? Do the licenses and permits critical to the business terminate if ownership of the company changes hands without the prior consent of the relevant regulator?

The answers to these questions tell us what events might need to happen before a buyer might be happy to proceed with completion. These steps often form the conditions precedent which must be fulfilled in order for completion to occur.

Can’t I rely on a full set of representations and warranties?

At times, a buyer might be reluctant to engage in due diligence or do ‘light touch’ due diligence if it knows it might be able to have the benefit of a fairly comprehensive set of representations and warranties from the seller.

The advantage of engaging in due diligence, rather than relying on contractual protection via representations and warranties, is that significant due diligence issues can be dealt with up front, as opposed to having to rely on suing for breach of representation or warranty if these issues are discovered after completion. In essence, this gives the buyer more options for dealing with these potential issues. Some due diligence issues may be so critical that the buyer wishes simply to walk away from the deal. Other due diligence issues might impact the buyer’s valuation of the target to such an extent that it might wish to negotiate a reduction of the purchase price. A buyer might want some due diligence issues to be rectified prior to or after completion and the seller’s co-operation in this process is often critical.

Due diligence puts the buyer in the position of knowing more information. On the whole, having more information than less puts the buyer in a better position and opens up a wider range of options for the buyer to take. Making a claim for a breach of representation or warranty is also an uncertain process. The buyer would need to prove in court that it had sustained a loss as a result of the breach and that it had fulfilled its obligation to mitigate its loss.

The impact of knowledge on ability to claim for a breach

Some buyers may be reluctant to engage in due diligence on the basis that the buyer may not be able to claim damages for a breach of representation or warranty successfully, where it had knowledge of the relevant circumstances prior to signing the transaction documents. In such circumstances, it may be difficult for the buyer to prove that it had sustained a loss as a result of the breach. The seller would argue that the buyer should have taken this information into consideration in the price it was willing to pay.

However, knowing more need not necessarily put the buyer in a worse position. If the seller, in the transaction documents, has agreed to indemnify the buyer against losses which would be incurred by the buyer in connection with the relevant circumstances, then the buyer might be able to make a claim under such indemnity even if it knew of the relevant circumstances before signing the transaction documents. 

The Due Diligence Risk Equation

In 2002, the then US Secretary of Defense Donald Rumsfeld famously said (in the context of possible weapons of mass destruction in Iraq):

There are known knowns – there are things we know we know. We also know there are known unknowns – that is to say we know there are some things which we do not know. But there are also unknown unknowns – the ones we don’t know we don’t know.

Due diligence can be thought of as the process of trying to turn known unknowns into known knowns, and as many unknown unknowns as possible into known unknowns or known knowns.

There are many potential risks involved in investing in a business. Due diligence enables us to learn more about these risks. Due diligence can enable us to see what risks which we think might potentially exist are actually present. Due diligence might also enable us to identify unknown unknowns, risks we previously never even considered could be there, and understand them.

Known and unknown risks can be dealt with by trying to understand them through further due diligence, through price adjustment or through contractual protections such as representations and warranties, indemnities, conditions precedent, pre-completion or post-completion covenants and/or retention of a proportion of the purchase price.

This is, in essence, the due diligence risk equation. A buyer typically has a particular level of investment risk tolerance. Where the collective risks inherent in the business present a level of risk too high for a buyer to bear, such transaction risk may be addressed through more extensive due diligence, a reduction in the purchase price or through increasing contractual protections.

Choosing the right legal due diligence team

Choosing the person who will manage the due diligence process at your end

So, you have decided to proceed with due diligence. The person that you choose to manage the due diligence process at your end is critical. They have an important role in communicating to the external advisers the scope of the due diligence exercise, what points to focus on and what is commercially important and material to the buyer. It is important that this person understands the transaction, its structure, the buyer’s strategic and commercial objectives, the basis of the buyer’s valuation, key value drivers and key risk concerns.

Choosing external legal counsel

It is important to select external legal counsel who have significant experience in legal due diligence and M&A transactions. They would ideally also have relevant experience in the target company’s industry. Due diligence on an oil and gas exploration business, for example, is a very different exercise to due diligence on an IT software company. Each due diligence exercise requires a degree of understanding of the legal architecture common to each type of business.

Too often, the task of due diligence is pushed down to the external legal counsel’s junior lawyers. The entire due diligence process must be managed and supervised by a lawyer who has experience with a significant number of M&A transactions so that she or he has developed the knowledge and skills necessary to identify material issues as they arise. Whilst it is not likely to be possible for that experienced lawyer to review all of the due diligence documents herself or himself, it is critical that she or he instructs a team of lawyers as to what issues to look out for in document review and closely supervises the entire process.

Working together

In a typical M&A transaction, the buyer normally carries out legal, financial and business or technical due diligence. The buyer may also conduct environmental, property, IT, privacy and data protection, tax, strategic, anti-bribery and corruption and background due diligence.

It is important that the buyer’s personnel managing the due diligence process ensures that each due diligence advisor coordinates with the others and is aware of the areas of enquiry and the results of due diligence from each.

It is often the case that due diligence issues picked up by one advisor are relevant to issues picked up by another. A well run due diligence process synthesises the analysis of all advisers in order to avoid due diligence blind spots.

Running due diligence

The scope of due diligence

After selecting your due diligence team, everyone is ready to dive into the data room and commence due diligence. However, it is all too common for due diligence to begin without a discussion as to what is inside and what is outside of the scope of due diligence, and what is most important to focus on.

The buyer and external counsel should work together to understand what the most important areas of inquiry are. This requires an understanding of the business, how it generates revenue, its main costs and liabilities, what its most important assets are and what the potential hotspots for issues are. The external counsel should bring its M&A and due diligence experience to the table and the buyer’s internal due diligence manager should add a closer understanding of the target company’s industry, the buyer’s areas of focus and the buyer’s relationship with the target.

There is no one-size-fits-all approach to due diligence. Due diligence on an industrial or manufacturing business may focus more on environmental and property issues and sales and supply contracts, whereas due diligence on a consumer-focused business may focus a lot more on brand, intellectual property, the competitive landscape and market expansion opportunities.

Overcoming a non-disclosure mentality

It is not uncommon, especially in emerging markets, or where the seller is not familiar with the M&A process, for the seller to think that it is not in its interest to disclose any negative information concerning the target to the buyer. Here, the seller is trying to market the best side of the business in order to obtain the highest price, rather than give the buyer a ‘warts and all’ view of the business.

There are situations where a buyer does not have much choice but to accept this approach. For example, where the deal needs to be consummated quickly before any other interested buyers surface, or where the seller has all of the bargaining power. Where this occurs, the buyer should try to protect itself, to the extent possible, through contractual protections or by factoring potential risks (which it is not able to due diligence) into its purchase price.

However, where there is room to move on this issue, it may be worthwhile explaining to the seller that it may be in the seller’s own interests to provide due diligence access and make disclosure of certain facts in order to qualify the representations and warranties in the transaction documents.

Using vendor due diligence

A due diligence report compiled by the seller is sometimes used in an auction scenario in order to assist bidders to get up to speed with the potential due diligence issues inherent in the target business. Vendor due diligence is often not comprehensive and is therefore not a substitute for the buyer’s own due diligence. However, it often provides a helpful start to the due diligence process, especially if the seller is prepared to make representations and warranties or provide indemnities in the transaction documents in relation to information contained in the vendor due diligence report.

The timing of due diligence

Due diligence should ideally commence as soon as due diligence materials are made available. Due diligence findings may need to be addressed in transaction documentation. In order to avoid asking for late changes to the transaction documents, the buyer should aim to complete substantially its due diligence as early as possible. Notwithstanding this, it is fairly common for due diligence to continue all the way to the signing of the transaction documents. The main reason for this is that it takes time for the seller to compile the due diligence documents and respond to further questions and requests for further documents.

The initial due diligence request list

The due diligence process often starts with the buyer sending to the seller a broad list of requests for documents and information. Before pulling the trigger on this first step, it is important to make sure that the due diligence request list is tailored to the target’s type of business and focuses on the relevant key areas.

Some sellers may prefer a more comprehensive initial due diligence request list, because the bulk of requests for information are received and can be dealt with at the one time. However, a very long list of requests often puts off sellers and target companies who simply do not have the time away from running their businesses to compile the requested information for the buyer.

Finding the right balance here is important. At times, it may be best to start with a very focused and short list of initial requests, zeroing in on the key issues which go to the heart of the deal in order to investigate potential deal breakers, before deciding to diligence deeper into the target company’s businesses.

Communication with the seller and the target

In order to keep the seller and the target onside during what can be a very involving due diligence process, it is important for the buyer’s due diligence manager to control the lines of communication with the seller and the target. The situation to avoid would be multiple advisers on the buyer’s side bombarding multiple personnel from the target or the seller with requests. Not only does this potentially put the target and the seller offside, it is a process which is very difficult to keep track of.

Channeling all due diligence communication through the buyer’s due diligence manager has two key advantages. It allows the buyer’s due diligence manager to keep a record of what questions have been asked by all advisers and what responses have been received, and it allows the buyer’s due diligence manager to understand what is happening across all streams of due diligence and to share information amongst the advisers to the extent relevant to their review.

The Due Diligence Report

What type of report do you need?

The final output of due diligence can range from a phonebook-length report summarising all documents which have been reviewed by external counsel, to one slide of a PowerPoint presentation to the buyer’s board of directors or investment committee containing a bullet point list of the most significant issues. The buyer should consider what it needs from the due diligence process and discuss this with external counsel.

Starting around 10 to 15 years ago, the trend in due diligence reports was to do away with lengthy summaries of all documents reviewed and to report only on an ‘exceptions’ basis. This means that the due diligence report would only mention issues identified from the due diligence exercise whose value or impact would be over a certain materiality threshold, which was often set at a monetary amount.

Whilst a material issues list does go directly to the heart of the due diligence issues, there are two potential issues with this approach. Firstly, if a dollar level of materiality has been set, there may be a risk of missing important issues which may not have a quantifiable impact on the business, or which may have an impact which is measured not merely in dollars. Potential examples include critical issues which are strategic, cultural or reputational in nature. Secondly, a list of material issues in isolation may not be very user friendly as the issues may not be clearly understandable without further explanation as to their fuller context. In order to deal with these two issues, external legal advisers often compile reports which include a list of material issues in the executive summary and include a broader description of the documents reviewed and other issues (which may not necessarily meet the dollar materiality threshold) in the back end.

What is there time to produce and act upon?

The choice of what type of due diligence report would be ideal may be impacted by the time available to conduct due diligence and compile the report. Where the transaction is very fast moving and the parties want to reach signing as soon as possible, the best achievable result from the due diligence exercise may be a list of issues which are discussed and more fully elaborated upon in a meeting or a call between the buyer and its external counsel.

Recommendations in the due diligence report

A good due diligence report should not only list the material issues identified in due diligence. It should also provide recommendations on how each issue could be dealt with. These recommendations are critical in understanding how best to use information uncovered in due diligence. Potential recommendations range from requesting further information, conducting further due diligence, factoring the information into the buyer’s valuation of the target, restructuring the transaction or the purchase price payment, including in the transaction documents the completion of remedial action as a condition precedent to completion, a pre- or post-completion undertaking or covering off the relevant risks with an indemnity.

Who will need to review or rely on the report?

It is important to consider who will need to review or rely on the report, in deciding the type of report that you need. Do you have financiers who will need to rely on your external counsel's due diligence report in order to lend? Do you anticipate requiring warranty and indemnity insurance, in which case the insurer may wish to review and also potentially rely on the report? In order to ensure that only one type of report needs to be produced, it would be essential to understand from the beginning how the report is intended to be used.

Using the report as a post-completion guide

One reason that a buyer may want its external legal counsel to produce a detailed due diligence report summarising all legal documents reviewed, is that this type of bible is a very helpful post-completion guide to the legal architecture of the business. A due diligence report of this type should allow the buyer, at a glance, to understand what legal documents exist and their key provisions. 

The disclosure letter

The effect of disclosures

The transaction documents may specify that the seller is not liable to the buyer for any breach of representation, warranty or indemnity in respect of matters disclosed in a disclosure letter.

The disclosure letter is a letter signed by the seller and given to the buyer at the same time as the signing of the transaction documents. It contains a list of statements or information disclosed and may refer to relevant documents provided to the buyer. Disclosures may be general in nature, where the buyer is deemed to have knowledge of all information in a particular category, for example the results of public searches or all material contained in the data room. Disclosure may also be made of specific information, often to qualify particular representations, warranties and/or indemnities.

The transaction documents will often state that such disclosures will only qualify the relevant representations, warranties and/or indemnities to the extent that they amount to fair disclosure – disclosure of the relevant facts with sufficient detail to identify the nature and scope of the matters disclosed.

Due diligence on disclosures

Given that the purpose of the disclosure letter is to carve potential issues out of the scope of the representations, warranties and indemnities given by the seller, it is a document which provides important information to be "diligenced". It is critical that the buyer understands the issues referred to in the disclosure letter and the extent that they impact the target business, given that the buyer's contractual protections in the transaction documents may not extend to these areas.

The buyer should ask the seller to provide its draft disclosure letter as early as possible. However, it is most often the case that the disclosure letter is provided close to the target signing date. The buyer should resist additional disclosures given by the seller at such a late stage that the buyer does not have sufficient time to conduct thorough due diligence on the disclosed information.

Key takeaways

Due diligence, by its very nature, is not a perfectly comprehensive process. There is no "standard" way to conduct due diligence. The process should be tailored to the target company you are investing in. To get the most out of legal due diligence, you need to understand the areas which are important to focus on and convey this to your external counsel. You should engage external counsel who are experienced and understand the due diligence process. Your external counsel should provide you with a due diligence report which is in the most useful format for you. The report should provide information which can be used as a key tool in the negotiation of the transaction documents. Legal due diligence can help you understand what you are buying and how much it is worth and at times it might help you to avoid a bad deal. It can give you the tools to negotiate a lower purchase price or negotiate contractual protections in the transaction documents.

Legal due diligence is a time consuming and often expensive process. However, when implemented properly, it forms an indispensable part of the overall M&A deal process.

Author:  Chin Yeoh, Partner, Hong Kong

Clients highlight the breadth of the firm’s practice: “Ashurst is able to give advice on almost all types of business and across Asia and Europe.” The group is praised for being user-friendly: “Ashurst has a team of experienced lawyers who are both approachable and efficient.” CHAMBERS ASIA-PACIFIC 2017

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The information provided is not intended to be a comprehensive review of all developments in the law and practice, or to cover all aspects of those referred to. Readers should take legal advice before applying it to specific issues or transactions.

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