Due Diligence

David Flacks, Partner | February 2002

Introduction

This paper sets out an overview of the due diligence process. It will focus on the following points in particular:

• What is due diligence?
• Why do due diligence?
• How is due diligence conducted?
• The due diligence report.
  

What is due diligence?

Due diligence has a wide range of scope and scale. However, there are essentially two types of due diligence:

• Firstly: Due diligence conducted in relation to a public offering of securities; and
  
  
• Secondly: Due diligence in relation to the potential purchase of the assets of or the shares in, an entity.
  

As this seminar relates to mergers and acquisitions, this paper will focus on the second type of due diligence, that is acquisition due diligence. Acquisition due diligence can be defined very generally as:

Due diligence is a procedure where an investor considering making an investment is provided with an opportunity to examine the asset concerned in some detail, normally prior to making a firm commitment to invest.

Although a vendor may also undertake a form of due diligence prior to a sale of assets or shares, this paper will focus on acquisition due diligence from a purchaser's perspective.

Why do due diligence?

The purpose of due diligence is to enable a purchaser to find out all they reasonably can about what they are buying, that is the material facts to help them decide whether to proceed. Purchasers need to be provided with a level of comfort that material information accurately reflects the assets and liabilities of the target.

Due diligence from a purchaser's perspective is about risk management. A wide range of risks exists for a purchaser and their financiers. Risks such as:

• the political risk associated with the countries in which the target is based eg. - a company based in Indonesia for example would currently have a high potential risk factor;
  
  
• the accuracy of past financial accounts of the target eg. - recent company management accounts were audited to reveal a substantial misstatement of earnings;
  
  
• whether the target's key staff, suppliers and customers will remain;
  
  
• whether the target has good title to its assets;
  
  
• whether the assets are worth the value the target attributes to them;
  
  
• whether there are any existing liabilities that may cause disruption in the future to the operations or financial performance of the target.

The vendor will typically have knowledge and information about these risks and legal issues, whereas a purchaser will not. Therefore, a purchaser will undertake due diligence to redress the knowledge imbalance between vendor and purchaser. Once those risks and legal issues are identified by the due diligence the burden of where the risks fall - purchaser or vendor, can be negotiated between the parties and the purchaser can decide on what terms it would proceed with the acquisition.

How is due diligence conducted?

Now we understand why due diligence is undertaken - we can look at how it is done. There is a wide range of scope and scale of due diligence, from privately held New Zealand companies with a single premises to an international conglomerate with offices around the world. Each due diligence review is unique.

However, the process for a due diligence on a large scale involving several potential purchasers is usually as follows:

1. The appointment by the vendor of an investment banker to co-ordinate the process and to negotiate with interested parties.
   
   
2. Appointment by each interested party of a due diligence team of experts (including lawyers, accountants and financial analysts).
   
   
3. The completion by interested purchasers and their advisers of Confidentiality Agreements.
   
   
4. The collation of all relevant material and preparation of an index by the vendor (and/or the target company at the direction of the vendor).
   
   
5. Preparation by each interested purchaser of a due diligence checklist.
   
   
6. The designation of a room (sometimes called a data room, a due diligence room and/or a war room) in which the relevant material is held under strictly controlled conditions. Where there are several potential purchasers, separate data rooms may be available to each of them.
   
   
7. The allocation of access to the data room to potential purchasers and their advisers usually for a limited duration of a few days in order to read materials.
   
   
8. Establishment of a procedure for addressing additional questions in relation to the target company and obtaining copies of data room material which is available for release.
   
   
9. Reports by advisers (lawyers, accountants, financial analysts etc) to the potential purchaser highlighting important issues to be considered in deciding the value of the target company. A legal Due Diligence Report will highlight material legal issues arising from the due diligence review and will normally include advise on the structure of the purchase and factors influencing the price to be paid, in the light of information obtained during the review.
   
   
10. The provision by the vendor of a draft agreement for sale and purchase and negotiating of amendments so that the agreement is finalised by the time a bid is submitted by the potential purchaser.

For smaller transactions the process may be simplified. Often the vendor (or the target company itself) will co-ordinate access to the relevant material, rather than use an investment banker. The vendor may not provide any material to the data room on the basis that it will simply respond to a request for material on an ad hoc basis. In such circumstances the potential purchasers may prepare a detailed written request for information. The preparation of a draft agreement for sale and purchase may not be completed until after the due diligence review has been completed and the parties have agreed on the basic terms of the transaction.

What do I need to keep in mind

Before a due diligence is undertaken the purchaser's advisers will want to consider the following points:

Focus - When entering into a due diligence you must be clear as to what your objectives are. Key concerns and objectives should be explained to advisers clearly.

Materiality - Determining the appropriate level of what is material to be applied in conducting the due diligence - ensures that the process is focused on your objectives and the identification of legal issues. It is a matter of determining what is reasonably likely to affect the value of what is being sold. Common sense not just predetermined figures should prevail.

Confidentiality - Before the purchaser has any access to any material the vendor will usually require some sort of confidentiality undertaking from the people involved in the due diligence, especially those people who will have access to confidential information. This agreement should permit full discussion and advice between the purchaser and all its advisers in respect of the confidential information.

Logistics - It is common on a large due diligence for a purchaser to have their own employees, together with advisers and other specialists conducting a review. It is important that systems are in place to ensure that the entire process is co-ordinated and remains focused on the purchaser's objectives.

What a legal due diligence should establish

The general things the legal review team should look for are:

• the assets have the value the vendor is giving them;
• the vendor has good title to these assets;
• there are no risks that reduce the value or use of those assets, essentially what legal issues are there;
• there are no other liabilities that may adversely affect the target such as tax liabilities.

Other things to look for include:

• Hidden or unexpected liabilities (eg environmental, superannuation, litigation);
• Change of control triggers in key agreements;
• Non-compete provisions or other restrictions on the target's ability to conduct business;
• Anti-assignment clauses in major agreements;
• Commerce Act or other regulatory obstacles.

You should also be aware of:

• Any regulatory or third party consents that need to be obtained;
• Any legal restrictions on business operation or plans that must be complied with or modified; and
• Any obligations to employees that will arise from the acquisition (such as superannuation liability and technical redundancy).

Share sale v Asset sale

Your approach to the review should be focused according to whether the type of transaction has been determined in advance. The results of the due diligence may affect which avenue you choose. The following chart summarises the key differences between a share and assets sale:

	Share acquisition	Asset purchase
1.	Involves sale of share capital in the Target by its shareholders to the Buyer.	Involves the Target itself selling assets to the Buyer.
2.	Liabilities of the Target continue to affect the Target after sale, unless agreed otherwise.	More limited liabilities and commitments pass with the transfer of the Target's assets.
3.	The Target's rights are not affected after sale, unless there are "change of control" provisions in effect. Purchasers should also look out for pre-emptive provisions in the company's constitution.	Title to the assets and rights have to be transferred by the Target to the Buyer. Where those rights involve a contract with a third party, their consent may be required to the assignment or the agreement novated with them being a party, unless there is no burden attaching to the right and consent is not required by the agreement

Use of specialist advisers

Areas where specialists may be necessary include:

• environmental matters
• property matters
• superannuation issues
• employment issues
• tax issues
• intellectual property matters
• Commerce Act matters
• litigation issues

The best due diligence are usually those involving a collaborative effort between the purchaser and its advisers. For example, if there are environmental risks, matching the in-house specialist with a specialist adviser, and preparing a pre-acquisition environmental audit can be extremely useful. It puts the purchaser in at least the same position as the vendor with information regarding the environmental risk, enabling equal negotiation of appropriate assumption of risk between the purchaser and vendor. The scope of the environmental audit will depend on the nature of the business that is being purchased.

Due Diligence Report

Normally after the material has been reviewed, and requests for information responded to, a report will be prepared for the purchaser.

A legal due diligence report will normally contain:

• An outline of the review requested by the purchaser;
  
  
• A list of the information reviewed, and information requested but not provided;
  
  
• Details of any assumptions made in conducting the due diligence;
  
  
• Any limitations or disclaimers of liability in making the report;
  
  
• A summary of the information reviewed, the legal issues identified, and advice as to the legal implications of such information.
  

A due diligence report is only as accurate and complete as the information on which it is based.

Due Diligence and Drafting

The due diligence process by identifying legal issues helps in the preparation and negotiation of the contracts for the transaction. It is better for a purchaser to have due diligence completed before drafting any agreements and in particular before drafting any warranties.

Identified risks and legal issues may impact on the structure of a transaction. By identifying risks and issues in advance, problem areas can be dealt with in the agreements so they are less likely to become the subject of a dispute after the transaction has been completed.