Due diligence cannot always be perfect. However, from a legal perspective, the point is to make a good faith effort to conduct due diligence, within the limits of time and funding, and in consideration of what matters most—the long-term financial health of the surviving company and its stakeholders. This author has written a comprehensive primer on the subject.
In a bestselling book published a generation ago, sociologist Alvin Toffler coined the term “future shock” to describe “too much change in too short a period of time.” This phrase certainly applies to due diligence today. In this new millennium, significant regulatory changes have affected due diligence in each of its four core areas: financial statements review, management and operations review, legal compliance review, and document and transactions review. Despite these changes, the timeless fundamentals of risk management apply.
The basic function of due diligence in any merger or acquisition is to assess the potential risks of a proposed transaction by inquiring into all relevant aspects of the past, present, and predictable future of the business to be purchased. The term is also used in securities law to describe the duty of care and review to be exercised by officers, directors, underwriters, and others in connection with public offerings of securities.
The due diligence effort in a merger transaction should include basic activities to meet diligence standards of common law and best practices. These activities include the following:
- Financial statements review, to confirm the existence of assets, liabilities, and equity in the balance sheet, and to determine the financial health of the company based on the income statement.
- Management and operations review, to determine quality and reliability of financial statements, and to gain a sense of contingencies beyond the financial statements.
- Legal compliance review, to check for potential future legal problems stemming from the target’s past.
- Document and transaction review, to ensure that the paperwork of the deal is in order and that the structure of the transaction is appropriate.
All of these areas have been affected by recent changes in law and accounting. Recent regulatory and accounting reforms in the United States, in the aftermath of Sarbanes-Oxley, make M&A due diligence somewhat easier. Now, based on rules promulgated under Section 404 of Sarbanes-Oxley, corporate leaders have greater accountability for the oversight of internal accounting controls, so company financials will tend to be cleaner. On the other hand, these same reforms, coupled with some recent, influential court decisions in Delaware, suggest heightened standards for the results of due diligence.
Requirements for due diligence
As mentioned, due diligence is found in securities laws. The two fundamental federal securities laws in the United States are the Securities Act of 1933 and the Securities Exchange Act of 1934. Both mandate a certain level of diligence with respect to securities, although neither mentions the term “due diligence” per se.
The Securities Act of 1933
This Act applies primarily to disclosures made when registering securities (debt or equity) for sale to the public. But it has broader implications. Some concepts in the 1933 Act, and in rules promulgated under it, have had far-reaching influence in court decisions. Therefore, mastering the disclosure principles in the 1933 act can help companies, both public and private, maintain good business practices.
Directors who are sued for violation of the 1933 Act can use proof of their “due diligence” as a legal defense. Section 11 of the Act requires accurate and complete disclosure of material facts in a securities offering registration statement. If a registration document contains misstatements or omissions of material facts, shareholders can sue the underwriters, accountants, and/or directors—and may prevail even without any proof of intentional wrongdoing. Defendants must show that in approving the statements, they relied on experts to a reasonable degree.
Section 11 is the single greatest source of liability for directors of public companies, and must be regarded with a great deal of attention — particularly the so-called “expertised portions” of the statement. In the language of a report from a Commission chaired by the past Delaware Supreme Court Chief Justice Norman Veasey, “When evaluating the reliability of the parts of the registration statement (or other disclosures) based on expert authority, directors should be satisfied that the expert is qualified and fully informed, and should remain alert for any red flags that would raise doubts about the reliability of those experts’ authority.”
The Securities Act of 1934
The Securities Exchange Act of 1934 is the sequel to the 1933 Act. Whereas the 1933 Act covers the registration of securities, the 1934 Act covers theirs exchange. Since many mergers involve the exchange of securities, the so-called “due diligence” portions of this law are particularly important for acquirers to master.
Like the 1933 Act, the 1934 Act does not use the term “due diligence” anywhere, but individuals accused of violating certain parts of the 1934 Act can use due diligence as a defense. In particular, a due diligence defense may be useful in defending against charges Section 10(b) of the 1934 Act, particularly Rule 10b-5.
Rule 10b-5 forbids certain practices deemed to constitute intentional fraud in connection with the purchase or sale of a security. The fraudulent behavior must be engaged in knowingly (or in legal Latin, there must be scienter). Legal complaints can come from any buyer or seller of a security who claims to be harmed by such a fraud—not just from the government.
The text of 10b-5, as amended, reads as follows:
It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails, or of any facility of any national securities exchange:
(a) To employ any device, scheme, or artifice to defraud,
(b) To make any untrue statement of a material fact or to omit to
state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or
(c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.
The “due diligence” defense cannot be used in all 10b-5 cases. If the fraud came from a conscious intent to deceive, the due diligence defense does not apply. It applies only in cases where the plaintiff alleges that the fraud in question stemmed from extreme negligence or recklessness. (As mentioned earlier, diligence is the opposite of negligence.)
Recent court cases do seem to include recklessness as a type of scienter fraud, thus making 10b-5 suits a threat to acquirers who have insufficient due diligence in the conduct of acquisitions involving public companies. Unless and until the courts reject recklessness as a type of scienter requirement, plaintiffs can cite a “breakdown in due diligence” as evidence in suing under 10b-5 or other private securities litigation. One of the best ways to ensure strong due diligence is to obtain independent verification of facts.
Independent verification of facts
In conducting a due diligence investigation, attorneys (or others) need to obtain independent verification of facts wherever reasonable. Reasonable, independent verification, based on accepted wisdom concerning due diligence in securities offerings, usually means referencing information sources outside the company as well as inside the company.
The famed case of Escott v. Barchris Construction Co. (1968) stated that it is “not sufficient to ask questions, to obtain which, if true, would be thought satisfactory, and to let it go at that, without seeking to ascertain from the records whether the answers in fact are true and complete.”
The final investigative reports in the bankruptcies of Enron and WorldCom faulted the board members and advisors who allegedly did not pay adequate attention to warning sign of financial troubles. These findings contributed to the directors’ decision to settle out of court. The large settlements in these cases suggest the increased importance of due diligence.
In favoring underwriters accused of negligence (lack of diligence), courts have been impressed with underwriter’s direct contacts with the issuing firm’s:
- Furthermore, verification can be achieved by examining documents to check officers’ statements.
- More generally, reviewing press reports about the company and its industry.
- Use of one’s own economic models to test those offered by the company.
- Verification may also mean cross-checking statements made by insiders — for example, speaking with lower-level employees to verify statements of upper level management.
On-site visits to the facilities of a company can prove diligence.
Clearly, all of these due diligence efforts are applicable to M&A due diligence, when an acquirer is looking to buy the shares or the assets of another company.
Cross-checking: A Good Idea
The courts are favorably impressed by efforts to “cross-check” representations. For example, do the reports add up if two division presidents both submit reports about the purpose and results of a joint project? Cross-checking is particularly important when one finds “questionable” information or “red flags.” This is a hot area of due diligence in offering statements. It is a recurring theme in recent government reports and judicial decisions judging actions of board members.
Acquirers should be alert to certain warning signs in each of the due diligence areas listed above (from financial due diligence to liability due diligence). All of these need to be investigated to some degree.
- Financial red flags include resignation of external or internal auditors, change in accounting methods, sales of stock by insiders, and unusual ratios. These may indicate fraud and/or insolvency.
- Operational red flags include very high or very low turnover and poor or inadequate reporting of important nonfinancial programs (quality, compliance). These may indicate unstable operations.
- Liability/compliance red flags include potential exposure to litigation from regulators, consumers, employees, and stockholders.
- Transactional red flags include conflicting accounting and tax goals. These need to be resolved early on.
Rules governing buyer’s potential liability
When one company sells or otherwise transfers all its assets to another company, the successor is not liable for the debts and tort liabilities of the predecessor. The successor may be liable, however, under the following circumstances:
- If it has expressly or implicitly agreed to assume liability.
- If the transaction is a merger or consolidation.
- If the successor is a “mere continuation” of the predecessor.
- If the transaction was fraudulently designed to escape liability.
A further exception exists for labor contracts. If the successor buys the predecessor’s assets and keeps its employees, the successor will probably also be bound to recognize and bargain with unions recognized by the predecessor, and to maintain existing employment terms. Existing contracts may also create successorship problems. State law may vary with respect to assumption of debts and liabilities, so the reviewer must be cognizant of the specific statutory or case law that will govern the transaction.
Courts are increasingly likely to find successor liability, particularly with respect to product liability claims, under the “continuity of product line” or “continuity of enterprise” exceptions to the general rule of nonliability. The first of these exceptions applies where the successor acquires a manufacturer in the same product line. The second exception applies where the successor continues the predecessor’s business.
Faced with an increasingly aggressive plaintiff’s bar in search of ever-deeper pockets, with the public and the courts searching for someone to blame, someone to shoulder the costs of injury to plaintiffs with no other course for recovery, the courts are increasingly looking to corporate successors for product-liability damage awards, including, in some instances, punitive damages. This trend is particularly egregious in the case of asbestos manufacturers, whose decade-long struggle to achieve a class settlement continues to this day. Accordingly, the due diligence reviewer must be aware of the current state of the law concerning successor liability for both compensatory and punitive damages.
(Fortunately there is a ray of hope in the Class Action Fairness Act (“CAFA”), signed into law by President Bush on Feb. 18, 2005. 28 U.S.C. §1332(d)(2). This makes it more difficult for plaintiffs’ attorneys to manipulate venues to prevail in court.)
As noted in the original edition of The Art of M&A, largely written by attorneys, litigation analysis of acquisition candidates requires a special procedure, usually conducted by trained litigation analysts. The primary reviewer obtains a list of all litigation, pending and threatened, and then gets copies of all relevant pleadings.
Before reviewing specific cases, the primary reviewer should ascertain what cases the seller believes are covered by liability insurance and then determine what cases, if any, are in fact covered. Because the two do not always coincide, it is critical to review all insurance policies.
The individual responsible for the litigation analysis must have a working knowledge of both the structure of the transaction—for example, whether it is to be a stock or asset purchase—and the corporate and tort law rules concerning successor liability for debts and torts, especially with regard to compensatory and punitive damages. These are then applied case by case. Any reviewer should have at hand the latest trends on director and officer (D&O) litigation. A leading source for this information is Tillinghast – Towers Perrin.
When acquiring a company, a buyer wants to make sure it won’t inherit a legal problem it didn’t know about. So the buyer must be alert to threats of possible litigation from various stakeholders. True to our theme of “future shock,” the following areas have been undergoing some change in recent years.
Customers — as well as competitors, suppliers, and other contractors—might sue over:
- contract disputes
- cost/quality/safety of product or service
- debt collection, including foreclosure
- deceptive trade practices
- extension/refusal of credit
- lender liability
- other customer/client issues
- restraint of trade
Employees — including current, past, or prospective employees or unions—might sue over:
- breach of employment contract
- employment conditions
- pension, welfare, or other employee benefits
- wrongful termination
Regulators might sue over:
- antitrust (in suits brought by government)
- environmental law
- health and safety law
Shareholders might sue over:
- contract disputes (with shareholders)
- divestitures or spin-offs
- dividend declaration or change
- duties to minority shareholders
- executive compensation (such as golden parachutes)
- financial performance/bankruptcy
- financial transactions (such as derivatives)
- fraudulent conveyance
- general breach of fiduciary duty
- inadequate disclosure
- insider trading
- investment or loan decisions
- M&A scenarios (target, bidder)
- proxy contents
- share repurchase
- stock offerings
Suppliers might sue over:
- antitrust (in suits brought by suppliers)
- business interference
- contract disputes
- copyright/patent infringement
- deceptive trade practices
Emerging legal Issues
Some issues crop up constantly as courts around the country offer legal theories, set new precedents, and abolish old ones. No list of such new legal theories could be complete, but here are a few to consider:
- To what extent can the head of a company be held accountable for the wrongful acts of subordinates? This “agency” theory is constantly being tested.
- To what extent can advisers rely on the word of management? To what extent can management rely on advisers? The nature of attorney–client privilege is changing rapidly, with courts demanding more skepticism on both sides.
- How many times can a company be sued for the same action? Is there a limit to the number of plaintiffs who can ask for punitive damages?
- What areas are the trial lawyers targeting? Visit the website of the American Trial Lawyers Association and see what hot topics they are discussing.
- Will fulfillment of change of control provisions give a departing or incoming CEO compensation that is unreasonable? If so, regulators (the Internal Revenue Service) or shareholders could try to sue directors and officers of a failure to fulfill their fiduciary duty of care. Since excessive CEO salaries are a concern right now, make sure you avoid perpetuating the problem with your transaction.
The following are questions used by tax courts to determine whether compensation paid to shareholders is reasonable, according to the American Institute of Certified Public Accountants:
- Would an unrelated outside investor consider the compensation reasonable?
- How does the amount of compensation compare with the amount of dividends paid?
- How does the compensation compare with the profit performance of the corporation?
- Was the level of compensation arranged in advance, or was it based on corporate profit?
- What is the typical level of compensation in the corporation’s industry?
A compensation package is likely to withstand IRS scrutiny if it approximates the amount that would be paid in an arm’s length transaction.
Consider the 2005 merger of Gillette and Procter & Gamble. Prior to the successful closing of that merger, shareholders filed lawsuits in a Delaware state court accusing Gillette of giving P&G “unduly favorable” terms while giving Gillette management “excessive compensation.” The plaintiffs sought class action status in an attempt to block the merger. Also in mid-2005, Massachusetts Secretary of the Commonwealth William F. Galvin investigated the fairness opinions used to justify the transaction. In the end, the company and executives prevailed and did not have to pay fines or “disgorge” (return) any pay.
Despite some of the changes outlined above, the fundamentals apply. Ultimately, the purpose of due diligence is to minimize risk. To anticipate and protect itself from future financial, operational, and legal problems, the acquirer must first check for problems common to all acquisitions, and then for problems common to the target’s industry, and finally, to risks in the target company. In seeking acquisition candidates in the first place, the acquirer can favor companies that have in place strong programs for risk management and legal compliance.
In addition, the acquirer can try to minimize the risk of the transaction in other ways:
- The acquirer can consult with a broker of liability insurance that protects directors and officers (D&O) of the acquiring company against acquisition-related risks, and to enter into an agreement with an insurance provider. Since D&O liability insurance providers employ actuaries who specialize in predicting risk, acquirers can learn a lot from talking to them. Insurance vendors are natural allies to those who seek to limit risk.
- Furthermore, the acquirer can make sure that its due diligence phase includes all the steps generally considered to show “due care” under common law.
- If suspicions arise during standard due diligence, acquirers can employ the services of private investigators to confirm them.
- The acquirer can include protective clauses in the documents that record the agreements between the parties.
- The acquirer can structure the transaction to minimize its risk.
- Finally, the acquirer can make sure that the various deal-related agreements it signs include adequate protections against post-acquisition losses stemming from pre-acquisition conditions.
Together with thorough due diligence, such steps can help to ensure the long-term success of any acquisition.
In the end, the diligence conducted must be reasonable, but it need not be perfect. Even if an expert can later find fault, the expert’s ability to poke holes in the “diligence” of investigators does not automatically create liability. Companies are complex entities operating in a complex world; no investigation can uncover all the potential risks of an acquisition. The point is to make a good faith effort to do so, within the limits of time and funding, and in consideration of what matters most — the long-term financial health of the surviving company and its stakeholders.